Options Fundamentals for Quant Trading

A crash course on the fundamentals of options trading including topics that are commonly asked in quant trading interviews.

TL;DR

• Options are derivative contracts that give the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specified price before a set expiration date.

• Market makers provide liquidity by continuously quoting bids and offers around a theoretical value, profiting from the spread collected across thousands of trades.

• Option pricing depends on five primary inputs: the underlying price, strike price, time to expiration, interest rates, and implied volatility.

• The Greeks—delta, gamma, theta, vega, and rho—measure how an option’s price responds to changes in these inputs and are the primary tools traders use to measure and manage risk.

• Volatility is the central variable in options trading. The relationship between implied volatility (the market’s expectation of future volatility) and realized volatility (what actually occurs) is a major driver of profits and losses for many options trading strategies, particularly those used by market makers.

• The core tradeoff in options trading is between gamma and theta: long options gain positive gamma, benefiting from large price moves but suffering from time decay, while short options collect theta but are exposed to large adverse moves.

Read More: In this article we cover the foundations of options and their applications in quant trading.

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