Derivatives – Introduction

This message is not intended to be academic; it aims to help readers understand a complex subject. I have no authority to advise anyone, and I do not recommend using the information here for any investment purpose. Read at your own risk or move on!

Some opening remarks:

• Investing in derivatives, such as stock options, can involve either risky speculation or hedging.
• Most investors “fail” by losing capital because they can’t manage the emotional strain, lack discipline, or make impulsive moves.
• Options trading requires dedicating “speculative capital” to this game, which “can be lost” (we don’t need this money for our daily lives or near-term investments), but this doesn’t mean we don’t value this capital—quite the opposite!
• A reputable broker requires investors to meet minimum criteria: passing a derivatives knowledge test (e.g., options) with a focus on risk awareness and maintaining a minimum capital level—typically at least USD 25,000. 
• Transaction costs are high, so you should avoid brokers who charge excessive fees for buying or selling a single contract, set large spreads (the difference between ask and bid prices), and increase the costs of maintaining a position and the amount of capital needed for margin and risk. 
• Be careful not to become addicted to adrenaline, as this can easily lead to “playing the cards,” or simply gambling.
• At the start of this journey, set a goal, align your strategy and tactics with it, and remain committed to them as if they were your independence.

My investment goals in the derivatives contracts market have shifted.

• Initially, my primary goal was to maximize profit. I was part of an international trading team (cost $500/month), led by our Guru, a former Wall Street broker who arranged transactions. We traded options only during the first hour after the market opened. He advised us on which contracts to open, at what prices, and when to close them. Over four months, I grew my initial $25,000 to about $100,000. Our group expanded quickly, and in the following months, some astute members began betting against one another by taking opposite positions at key moments. Sadly, our Guru unexpectedly passed away from cancer, which led to the group’s disbandment. Feeling successful, I thought I was an expert, but within a few months, I lost all my profits and was left with only the minimum capital. This experience taught me that the main goal in this game is, above all, NOT LOSING CAPITAL.
• Once I learned to respect capital, I set the second goal of this game to earn a consistent daily profit of $100 to $200 through options trading. I stayed at the Marriott Hotel in Pattaya, Thailand, for three weeks, planning to relax and write a book, but I only managed to write the introduction because I was mainly enjoying life and trading stocks. During that time, I decided it would be great to earn at least $100 to $200 per day so I could live comfortably somewhere nice in the world—not Manhattan—and cover my daily expenses. The goal seemed modest, but it was not so easy to achieve. After several years of experimentation, I can confidently say I’ve long since accomplished it. I’ve traveled extensively in the meantime, and now, after turning 70, I don’t particularly want to fly around the world anymore.
• My current goal is to maintain the modified goal number 1 (not to lose capital), goal number 2 (small profits but systematic), plus a new goal: “let have a FUN FUN FUN,” which means intellectual entertainment—stopping the aging process of the mind and gaining personal satisfaction from a good game.

The core of a derivative instrument

OPTION – It is essentially a possibility, a so-called derivative right, linked to an underlying asset, which can be a share of a public company, a bond, a currency, a cryptocurrency, an ETF/ETN, or anything else. However, here we only deal with derivative instruments admitted to public listing on capital exchanges.

In business transactions, so-called real options (as opposed to standardized financial options) are defined in various types of contracts, such as investment and commercial agreements. Generally, such a clause in a contract gives one party a right (which they can choose to exercise or not) and the other party an obligation (which they must fulfill unconditionally). When the contract is signed, the validity period of this right and the value of a specific action (the value of exercising the right) relative to the value of the contract’s subject (the underlying asset) are established. The holder of the right will not enforce it if doing so would result in a financial loss. The other party to the contract has an obligation that cannot be waived.

An option is a standardized derivative contract traded publicly on a stock exchange. In specialized jargon, each party involved in an option transaction, after completing the exchange, takes on a ‘position’: either a long position (buying the contract) or a short position (selling the contract).

Closing a long position occurs when the contract owner executes a reverse transaction (selling the contract on the stock exchange) or requests that the party holding a short position in the contract perform the obligation arising from the option. It can also occur automatically, without any underlying asset transaction, on the option’s expiration date.

Closing a short position works similarly, but it can also happen if there’s a request to exercise the right of the owner of a long position in that option.

Investors take positions (long or short) in a single option, which, in the case of a stock as the underlying asset, would be the right to buy or sell a block of 100 shares, or they engage in an options strategy, which involves a portfolio of several different options characterized by a specific profit or loss profile, risk level, expiration period, and rights and obligations.

In stock market terminology, you can take long or short positions in options, such as calls (the right to buy the underlying asset) or puts (the right to sell the underlying asset).

We therefore present four different cases of occupied positions:

LCALL:                 Bought the right to buy the underlying asset (Long Call)

SCALL:                Issued (sold) the right to buy the underlying asset (Short Call)

LPUT:                  Bought the right to sell the underlying asset (Long Put) has been purchased.

SPUT:                  Issued (sold) the right to sell the underlying asset (Short Put)

A Closer Look at Long and Short Positions Using Stock Options as an Example:

• The option buyer takes a so-called long position; they purchase from the option seller the right to benefit from the difference between the share price and the option strike price until the option expires, a reverse transaction is completed, or the option buyer decides to exercise the option—that is, to fulfill their request to buy or sell shares from or to the option seller. This involves the option buyer paying an option premium and other transaction costs.
• The option writer, or option seller, takes a short position: they sell the right to the option buyer, agreeing to fulfill the buyer’s right in exchange for an option premium set on the transaction date. This premium can fluctuate over time, reflecting the current difference between the share price and the option’s exercise price until the option expires or until a reverse transaction occurs—such as buying back the option if there’s a purchase offer—or until the buyer requests to exercise their right, which means to buy the shares from the writer or sell shares to them.

Let’s verify this with a numerical example.

The buyer of the AAPLMay15 25, 250Call option has acquired the right to buy 100 shares of Apple stock for $250 per share (the strike price), regardless of the current Apple stock price (quotation). Their right expires on May 15, 2025. During the period from when they take a long position until the expiration date, the buyer can sell this option (dispose of their right if there are offers to purchase) or ask the other party to exercise their right (in this market, the number of long positions always equals the number of short positions).

This purchase would not have occurred without a writer of the AAPLMay15 25, 250 call option, who, as a result, takes a short position and assumes the obligation to exercise the buyer’s right upon request, no later than the expiration date. The fulfillment includes delivering 100 shares at the exercise price of USD 250 per share, regardless of the current Apple stock price. The writer of the SCALL option already owns such shares or can purchase them at any time to meet their obligation.

The option buyer pays the option premium (OP) to the other party in the transaction, the option writer (for the obligation the option writer has assumed). At the same time, brokers act as intermediaries, earning money through transaction costs for both parties. The option writer receives the option premium (OP) from the option buyer upon entering the position (concluding the transaction).

Shares are currently held electronically. They are authorized to trade on the stock exchange in limited amounts. You can buy and sell shares even if you don’t own them, a practice called short selling. In this case, the broker lends you shares to sell; you must repurchase them and return them. Naturally, all of this happens automatically if you have the necessary capital and permission to engage in such transactions.

Unlike shares, an option is a right described in the underlying instrument (in this case, a share) and does not exist until a potential buyer offers to acquire it and the issuer delivers it. The act of purchase or sale creates an option (a contract or a kind of bet). This contract is standardized, and one option represents the buyer’s right and the issuer’s obligation regarding a block of 100 shares. Therefore, when an option is quoted (valued or offered on an exchange), its transaction price (quotation on the exchange) equals 1/100 of the capital needed to purchase the option. The option price has a somewhat complex relationship to the share price (but that’s another story).

Transaction example.

The price of one share is USD 100, and the purchase price of a Call option (which gives the right to buy 100 shares at a fixed exercise price before or at the expiration) is USD 3.50 per option (the option price). 

This indicates that:

• The buyer of 1 option will pay USD 350, which is USD 3.5 multiplied by 100, to acquire the right to dispose of a block of 100 shares currently worth USD 10,000, or USD 100 per share. For USD 350, the buyer of 1 option becomes the holder of the right – but not the obligation- to buy or sell a block of 100 shares at a predetermined price (option exercise price, e.g., USD 110 per share) during the validity period of this right (option expiration date, e.g., 2 weeks), regardless of the share price on the date of the reverse transaction (sale of the option) or the date of expiration/exercise of the option right.
• The issuer of this option will receive USD 350 and agrees to exercise the purchaser’s right, which is to deliver or buy from him a block of shares currently worth USD 10,000 at the option exercise price (USD 110 per share), regardless of the share price on the date of the reverse transaction (sale of the option) or on the expiration or exercise date of the option rights.
• The PO option premium amount (option price) has a complex structure and generally consists of two elements:
  • The value of the risk associated with holding or issuing the option for the remaining period until expiration (the time premium), which decreases over time assuming no other parameters change.
  • The price difference between the current share price on the option valuation date (the option’s quote on the stock exchange) and the option strike price. In the case of a call option, if the buyer purchased the option for $3.50 per option with the right to buy shares at a strike price of $110 per share in two weeks, the option premium (option price) on the option purchase or issue date would consist of:
    • (-10) USD/share represents the difference between the current share price and the option exercise price. For example, -10 USD equals 100 USD/share minus 110 USD/share (this is known as the intrinsic value of the option or “IntrinsicValue” – IV). In this case, it is negative because, at the current share price of 100 USD, the option allows you to buy a share at 110 USD, which is irrational and would result in a 10 USD/share loss. However, there are still two weeks remaining until the option expires, and many things could happen, such as an increase in the share price to 120 USD,
    • (+13.5) USD/share represents the “time premium” until option expiration (also known as “Time Value” – TV), where 13.5 USD equals 3.5 USD minus (-10) USD. For example, if the current share price stays at 100 USD/share until the option’s expiration date (call option), the option buyer’s loss will be 100% of the invested capital, which is 350 USD, because the time premium of 13.5 USD per option will drop to zero within two weeks. The difference between the share price and the strike price will stay negative. From the perspective of the right to buy shares at 110 USD/share, exercising this right makes no sense if, at expiration, the share price is 100 USD/share; therefore, the value of this right is zero. In practice, the buyer of the call option will realize a profit only if the share price exceeds USD 113.5/share (USD 100 + USD 13.5) by the expiration date.
    • The option buyer has another vital right—the so-called exercise right—which allows them to demand that the option be exercised at any time during its validity period. This means they can compel the option writer to deliver a block of 100 shares (in the case of a Call option) or to buy back a block of 100 shares held by the option buyer (in the case of a Put option). In our example of a Call option, if the stock suddenly rises to USD 120, the buyer of a CALL option with a strike price of USD 110 could:
      • Sell the call option for a price of, for example, USD 20, calculated as 120 – 110 + USD 10, where USD 10 is from the difference in the share price and USD 10 is from the remaining time premium that was originally USD 13.50. From this transaction, he will receive USD 2,000 for the sold option, compared to the USD 350 cost of purchasing this option, meaning his net profit will be USD 1,650 on one contract, or
      • He can exercise his option (his right to purchase 100 shares) at $110/share and then sell the shares at $120/share. In this scenario, he will pay $11,000 ($110/share × 100 shares) to buy a block of 100 shares from the option writer and sell them immediately for $120/share. His income will be $ 12,000 – $11,000, which should be reduced by $350 (the cost of buying the option), resulting in a net profit of $650. As you can see, the time premium of USD 1,000 = USD 10/share * 100 has evaporated from the account, which means that in practice, the request to exercise the option usually happens at the last moment before the option expires (when the time premium has little value and the buyer of the option actually wanted to buy the shares and only temporarily committed part of the capital to buy the option, waiting for a favorable development of events).

I know that cash is king. Therefore, I prefer to receive the $350 by writing the option rather than paying for it outright.

The part of the option price linked to its expiration date (the time premium) declines to zero at expiration. Therefore, from a time premium standpoint, this usually benefits the option writer and disadvantages the option buyer.

The option buyer has spent $350 and watches helplessly as the time premium they paid (in the option price) steadily decreases. When the stock price and other market factors remain the same, such an option can only be sold at a lower price over time, or not at all if there is no demand for it. The option writer, on the other hand, received USD 350 and is pleased to see that a growing portion of that amount already belongs to him. This is because when the share price and other market factors remain stable, he can buy back the written (sold) option for less. There’s even a chance the entire PO premium will stay with him on the option’s expiration date if the share price remains stable.

Unfortunately, it’s not that simple!

Each long and short position has its own advantages, disadvantages, and uses. Interestingly, statistics show that option buyers (those who take long positions) tend to lose more than option writers (those who take short positions).

CASH IS THE KING!

Why is it less risky to take on obligations than to have rights?

PURE HERESY?

Initially, I looked for inspiration and explanations for this problem in various academic publications, such as “The complete guide to option selling – How selling options can lead to stellar returns in bull and bear markets” by James Cordier & Michael Gross, McGraw–Hill (Finance & Investment), 2004.

A few years later, I refined my options strategy by using short positions, but only after mastering new skills to exploit market price volatility.

This knowledge was contained in the second publication essential to my investment education: “The volatility edge in options trading – new technical strategies for investing in unstable markets” – Jeff Augen, Pearson Education Corp., 2008.

Stock price volatility (also called volatility) is a key factor, along with the time to expiration and the difference between the current stock price and the option’s strike price, that determines the option’s valuation (the current stock market price of the option) and, therefore, the desired option premium. Sometimes, a sudden increase in volatility can cause the option price to rise sharply on the same trading day, even when the time to expiration is nearly the same, and the stock price has not changed.

The volatility index is affected not only by the historical volatility of stocks as the underlying assets for options but also by regional or global market volatility and market news that provoke strong emotional reactions among investors in response to temporary positive or negative events (such as an unexpected decision to pay a dividend or the release of surprising results and outlooks for the underlying asset, a large block of shares bought or sold by a member of the company’s management team, known as inside trading, or a surprising endorsement from well-known stock analysts). Not to forget the proverbial “butterfly in the dark.”

Another factor affecting option prices is the risk-free interest rate, such as the yield on government bonds. This factor is less significant for short-term traders, except right before and after the central bank’s decision announcement.

For now, I’ll set aside the knowledge and skills of fundamental and technical analysis, which are, of course, essential for any investor. It’s important to evaluate the underlying asset—in our case, a joint-stock company—from the perspective of its financial health, objectives, market perception, current investor valuation, and price trend, considering the characteristics of the intended options transaction.

The moment when we make the transaction is also essential – MOMENTUM IS THE KING – almost the most crucial factor in any short-term investing.

Choosing a broker is a vital step in investing. I recommend selecting only the most reputable international companies whose shares are listed on a stock exchange that offer highly liquid, low-cost transactions and guarantee capital protection at least as good as that offered by banks.

This was just an introduction, to be continued in the following articles: Derivatives Part 1 and Derivatives Part 2

Don’t hesitate to get in touch with me if you have any questions. I will clarify them, but please note that I never give advice.