Derivatives Trading

This post captures foundational knowledge that will help master Australian derivates trading.

• Options Fundamentals
  • Call Option Analogy: Renting the Right to Buy a House Later
  • Put Option Analogy: Renting the Right to Sell a House Later
  • American vs European
  • Buyer vs Seller
  • Options Bring Flexibility
  • The Value of an Option
  • Option Premiums
• Spread Trading
• Portfolio Strategies - Covered Calls
• Options Cheatsheet
• Glossary
• Indicators

Options Fundamentals

An option is a contract that gives you the right, but not the obligation, to buy or sell a stock at a specific price (called the strike price) before a certain date (the expiration date).

There are two types:

Call Option Analogy: Renting the Right to Buy a House Later

Imagine you’re dealing with houses instead of stocks.

You find a house you might want to buy in the future. You pay the owner $500 today to get the option to buy it for $100,000 anytime in the next 3 months.

If the house’s market value jumps to $120,000, you still get to buy it for $100,000—you just made a $20,000 profit (minus the $500 you paid).

If the house’s value drops to $90,000, you can walk away. You lose the $500, but you’re not forced to buy.

Put Option Analogy: Renting the Right to Sell a House Later

Now imagine you own a house and you’re worried its value might drop. You pay $500 for the option to sell it for $100,000 anytime in the next 3 months.

If the market crashes and the house is only worth $80,000, you still get to sell it for $100,000, you just saved $20,000.

If the house goes up to $110,000, you ignore the option and sell it at market price. You lose the $500, but that’s okay.

American vs European

It comes down to WHEN the option can be exercised.

American Options:

• Can be exercised at any time before or on the expiration date
• More flexible for the buyer
• Most stock options in the US are American-style

European Options:

• Can only be exercised on the expiration date itself
• No early exercise allowed
• Common for index options (like SPX)

The difference matters most when you want to lock in profits or cut losses before expiration. With American options, you have that choice. With European options, you’re locked in until expiration day. Though you can still sell the option in the market before then to exit your position.

American options are generally slightly more valuable due to this added flexibility, though in practice most option holders close positions by selling rather than exercising anyway.

Buyer vs Seller

You pay a premium upfront to purchase this right. The option’s value fluctuates based on the underlying stock’s price movements, time remaining until expiration, and other factors like volatility. If the option becomes profitable, you can either exercise it (buy/sell the stock) or sell the option itself for a profit. If it expires worthless, you only lose the premium you paid.

The traits of a Call or Put invert depending if you are the buyer or the seller (aka writer):

Time decay impacts the buyer and seller in opposite ways:

• Buyers fight against time decay. They need the stock to move significantly and quickly.
• Sellers benefit from time decay. They profit as the option loses value over time, even if the stock doesn’t move.

Notes:

• Premium = IntrinsicValue + TimeValue
• Its rare that you want options to be exercised, except for Covered Calls or Covered Puts.

Options Bring Flexibility

Several strategies that allow you to profit from different market scenarios:

Directional plays:

• Bullish: Buy calls to profit from price increases
• Bearish: Buy puts to profit from price decreases

Non-directional strategies:

• Straddle: Buy both a call and put at the same strike price. You profit if the stock makes a large move in either direction, regardless of which way it goes. This bets on volatility, not direction.
• Sideways: Sell options (like iron condors or strangles) to collect premiums when you expect the stock to stay relatively flat

Risk management:

• Hedge existing stock positions against losses
• Cap your downside to just the premium paid (when buying options)
• Generate income by selling options against stocks you own (covered calls)

Leverage:

• Control large amounts of stock with relatively small capital
• Amplify gains (and losses) compared to owning the stock directly

The core flexibility comes from combining different strike prices, expiration dates, and option types (calls/puts) to create strategies tailored to your specific market outlook and risk tolerance.

The Value of an Option

An option’s total price (premium) = Intrinsic value + Time value

Intrinsic value:

The profit you could lock in right now if you exercised the option (zero if the option is out-of-the-money).

If an option allows you to either buy stock cheaper (Call), or sell stock for more (Put), than the share price, it has intrinsic value.

Time value:

The extra amount people pay for the possibility that the option becomes more valuable before expiration.

Time value erodes as expiration approaches. This is known as Time decay (theta). The closer you get to expiration, the less time there is for the stock to make a favorable move, so the time value decreases.

Time value doesn’t disappear linearly. It erodes slowly at first, then accelerates rapidly in the final 30-60 days, with the steepest drop in the last few weeks. Think logarithmic decay.

Time decay example:

• A stock trades at $100
• A $100 call option with 6 months until expiration costs $8
• Since the stock is exactly at the strike price, intrinsic value = $0
• The entire $8 is time value. You’re paying for the chance the stock rises above $100 before expiration.

Call Value Example:

╔════════════════════════════════════╗
║                                    ║
║        === Call Option ===         ║
║                                    ║
║        Share price: $31.00         ║
║        Strike price: $30.50        ║
║        Expiry: 25 November         ║
║        Option Value: $0.72         ║
║                                    ║
╚════════════════════════════════════╝

• Intinsic value = $0.50 ($31.00 - $30.50)
• Time value = $0.22 ($0.72 - $0.50)

Scenario 1: One week later, share price increase:

╔════════════════════════════════════╗
║                                    ║
║        === Call Option ===         ║
║                                    ║
║        Share price: $32.00         ║
║        Strike price: $30.50        ║
║        Expiry: 25 November         ║
║        Option Value: $1.68         ║
║                                    ║
╚════════════════════════════════════╝

• Intinsic value = $1.50 ($32.00 - $30.50)
• Time value = $0.18 ($1.68 - $1.50)
• Profit = 233% = 2.3X = ($1.68 / $0.72 × 100)

A 233% profit off a ~3% increase in share price.

Scenario 2: One week later, share price decrease:

╔════════════════════════════════════╗
║                                    ║
║        === Call Option ===         ║
║                                    ║
║        Share price: $29.50         ║
║        Strike price: $30.50        ║
║        Expiry: 25 November         ║
║        Option Value: $0.18         ║
║                                    ║
╚════════════════════════════════════╝

• Intinsic value = -$1.00 ($29.50 - $30.50)
• Time value = $0.18 ($0.18 - 0)
• Loss = -75% = 0.25X = ($0.18 / $0.72 × 100)

A 75% loss off a ~5% decrease in share price.

Option Premiums

The premium listed is the per-share price, but you must buy options in contracts of 100 shares.

If you see a Call Option quoted at $3.50, that’s the price per share. To calculate your actual cost:

Total cost = Premium × 100 shares per contract × Number of contracts

Example:

• Option premium listed: $3.50
• You buy 1 contract
• Total code = $350 = $3.50 × 100

If you bought 5 contracts at $3.50:

• Total cost = $1750 = $3.50 × 100 × 5

This standardisation means even “cheap” options can require meaningful capital. A $0.50 option still costs you $50 per contract. It also means your profit and loss calculations scale by 100. If that $3.50 option increases to $5.00, you don’t make $1.50, you make $150 per contract (minus the premium you paid).

This is part of the leverage component of options; you control 100 shares of stock for a fraction of what it would cost to buy them outright.

Spread Trading

Iron Condor

Portfolio Strategies - Covered Calls

Options Cheatsheet

1. Options are bought in contracts; contract size is usually 100 shares per contract.
2. Calculate break even by adding (call) or subtracting (put), the option value from the strike price.

Glossary

Indicators