Developing Options Intuition (Draft)
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Developing Options Intuition (Draft)

A Curious Person's Guide To Developing Intuitions About Vanilla Options Pricing and Behavior

About the Book

This book is a work in progress. It is being distributed for free until I feel it is sufficiently polished to charge for it, as a way for me to get feedback on the content.

I Like Options.

People often say they're dangerous, and they can be, but I think the fear comes from a place of distrust of the unknown.

Some people who "know options" seem to only understand them very superficially and just "understand" that:

  1. 80%+ of options finish out of the money, so its easy to lose 100% of your investment
  2. selling options is a surefire way to be exposed to "infinite losses"

which, in combination, sounds like a really good reason to never buy and never sell an option.

Stop Fake Learning

You probably know a lot of people who know how to add.They don't just know that 5+7=12 because that's a fact they memorized. Some time in kindergarten, someone explained to them that if you take 5 apples and 7 apples, put them in a pile, and count the group, that's the sum. That's a really digestible thing for most people and people don't really forget how to add much.

But somewhere around university, people don't really understand math. They can't explain calculus. They know "rules" like "a2 + b2 = c2" or they can repeat the quadratic equation by singing a song. They know that if you can take the derivative of a polynomial by "moving the exponent down" -- but they don't really know what any of that means or how it came to be. Eventually they forget it and say "I'm not good at math".

Similarly, there are business school grads all over the country that can draw a call expiration diagram but they don't really have a clue whats going on under the hood with options. These are failures of teaching.

I Want You To Like Options

I think options are misunderstood, interesting, complex, powerful and wonderfully elegant. They can be fun and easily explained -- they just require a different narrative than the traditional one. If you'll give me a chance, I want to tell you some half-truths and idealized explanations that will help you approach options in a different way to develop intuitions about options and begin the path to a more meaningful understanding of the topic.

This is meant as a supplement, not a replacement, to basic options education.

About the Author


Hi I'm Eric Liu

I used to be an options trader and risk manager. I've worked in proprietary trading operations as big as 400+ and as small 1.

Now I work full time on my startup, Rocket Lease.

I like smoked BBQ brisket, Taylor Swift, and long walks on the beach.

Follow me on twitter: @ezliu or email me:

Table of Contents

  • Introduction
  • What Are Options?
  • Option Trade Example
  • Anatomy of an Option Symbol
  • Sample Trade Mechanics
  • Option Expiration Payouts
  • Long Call
  • Short Call
  • Long Put
  • Short Put
  • Exercises
  • Random Walks
  • Example
  • Volatility Value
  • A Basic Intuition For Option Pricing
  • Games of Chance
  • Flipping a Coin
  • Rolling Dice
  • Option Prices As Expected Value
  • Recap
  • Replicating Portfolio
  • Buying Options: Climbing Out of a Hole
  • Selling Options: Walking down a Hill
  • How Does The Replicating Portfolio Make Money?
  • Option Pricing Models
  • Understanding Black-Scholes
  • C = S * N(d1) - X * e(-rt) * N(d2)
  • What Are The Benefits?
  • What Is The Cost?
  • How Much Is A Call Worth?
  • A closer look at N(d1) & N(d2)
  • Cox, Ross, and Rubenstein – Binomial Trees
  • Temporary End
  • Temporary End
  • Other Ideas
  • Side Note: Usage Gripe
  • an h2
  • another h2
  • an h3
  • an h4
  • an h5
  • an h5
  • an h4
  • an h4
  • Code Samples
  • Geometric Brownian Motion

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