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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