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Options Theory: Derivatives and the 3D’s

September 3, 2017

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Traders born in the equities market are obsessive about one principal question: up or down? Theirs is a game of directional betting and directional betting only. It’s not very sophisticated when you think about it. Like two cavemen communicating with grunts and hand gestures, it’s a language of very few expressions.

And there’s certainly a beauty to the simplicity. Just ask any new trader how they feel about stock trading’s binary nature. They love it. No matter how you dissect the chart of Apple the potential takeaways are limited to buy or sell, long or short. And to a starry-eyed novice bombarded with information, knowing that they ultimately are deciding between one of two roads makes a challenging task seem, well, less so.

But simple doesn’t mean easy. As the mass graveyard brimming with the bones of once promising traders will attest, predicting direction can be a tricky feat.

Fortunately, there are multiple dimensions to the game of trading, at least, if you’re willing to venture into the enticing den of derivatives.

Since this may be the first time some of you have come across the term “derivatives”, a brief description is in order. On Wall Street, a derivative is simply a security that derives its value from something else, some underlying asset. The analogy I’m fond of is that of a pizza coupon which is a derivative of sorts. The only reason a pizza coupon has value is because the underlying asset – that is, pizza – has value. As the price of pizza rises, the value of the derivative (the pizza coupon) rises. And vice versa for a fall in pizza prices.

The most popular type of derivative product for retail traders like us is an options contract. You will often hear individuals use the terms interchangeably. You say you trade options; I say you trade derivatives. Tomayto, tomahto. Only the word derivatives sounds infinitely cooler.

The single dimension of stock trading, the perpetual “which direction?” question is also relevant to options traders. But how relevant the query depends in large part on how you structure your position. Some strategies care very much about which direction the stock travels while others don’t care much at all.

This is where the other two dimensions come in: time and velocity. Collectively, direction, time, and velocity make up the three dimensions of derivatives trading.

If we were to express “time” as a question, it would be “how long?”

If we were to express “velocity” as a question, it would be “how far?”

Both queries matter little to stock traders, but much to options traders. For example, say you purchase shares of AAPL stock for $100. If the stock rises, you win. Simple as that. But what if it takes three months to rise? Well, you still win. What if it only rises $1 over that three months? Again, you still win. It doesn’t matter how long it takes or how far it rises. If it climbs at all, you win.

Derivatives aren’t so straightforward. Suppose instead of purchasing stock for $100, you bought a three month 100 strike call option for $4. To win – that is, to capture a profit – AAPL doesn’t just have to advance, it has to advance far enough, fast enough. If it climbs far enough but takes too long, you will lose. If it rises quickly, but not far enough, you lose. Again, we need all three variables to work in tandem.

And that makes options trading quite a bit more complicated than stock trading. But here’s the beautiful thing. With these two extra dimensions, the doors to volatility and time-based trades are opened. No longer are you relegated to directional betting only. Now, you can bet how far a stock will or won’t move. Or how long it will take to run. And that introduces a whole new world of speculation, one teeming with possibilities, especially for stock traders tiring of the difficulty gambit that is guessing market direction.


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6 Replies to “Options Theory: Derivatives and the 3D’s”

  1. KENNETHLAWRENCE says:

    Straightforward, clear and helpful. Thanks!

  2. TylerCraig says:

    You bet, Kenneth. Thanks for reading!

  3. CHUCKHAUGER says:

    This helps jog some memories of option 1 class. Plus it helps when people ask what are we doing.
    Thanks Tyler

  4. ThiagoMalena says:

    Great explanation Tyler. Thanks a lot!

  5. ASHISHVAIDYA says:

    Awesome article. Loved the simplicity yet sufficient detail.

  6. ASHISHVAIDYA says:

    Awesome article. Loved it.

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