Costs, Benefits, and Risks of Derivative Securities

This section covers the characteristics of every major derivative type: option premium components, moneyness, hedging strategies, exercise mechanics, and the cost/benefit/risk profile for options, warrants, rights, futures, and forwards.

Option Premium Components

Premium = Intrinsic Value + Time Value

Intrinsic value:

• The amount an option is in-the-money
• Call intrinsic value = Market price - Strike price (if positive; otherwise $0)
• Put intrinsic value = Strike price - Market price (if positive; otherwise $0)
• Intrinsic value can never be negative (minimum is $0)

Time value (extrinsic value):

• Time value = Premium - Intrinsic value
• Represents the possibility that the option will become more profitable before expiration
• Decreases as expiration approaches (time decay / theta)
• An out-of-the-money option's entire premium is time value
• Greater volatility of the underlying = higher time value
• Longer time to expiration = higher time value

Exam Tip: Gotchas

An option can have time value even when it has zero intrinsic value (out-of-the-money). But at expiration, only intrinsic value remains; time value drops to zero.

Moneyness

• Only in-the-money options have intrinsic value
• At expiration, only in-the-money options are exercised
• ATM and OTM options expire worthless

Exam Tip: Gotchas

For CALLS, "in-the-money" means market price is ABOVE the strike. For PUTS, it is the opposite. Memory aid: "Call UP, Put DOWN."

Maximum Gain, Maximum Loss, and Breakeven

• Buyers (long) have rights; max loss = premium paid
• Sellers (writers, short) have obligations; collect premium, bear greater risk
• Uncovered (naked) call writing has unlimited theoretical loss, the single most dangerous options strategy

Exam Tip: Gotchas

Breakeven formulas are the same for buyer and seller of the same option type. The difference is which side profits above or below that point. Calls: Strike + Premium. Puts: Strike - Premium.

Hedging Strategies

Protective put (long stock + long put):

• Provides downside insurance on a stock position
• Max loss = (Stock purchase price - Strike price) + Premium paid
• Max gain = Unlimited (stock can rise indefinitely)
• Breakeven = Stock purchase price + Premium paid
• Most conservative hedging strategy for a long stock position

Covered call (long stock + short call):

• Generates income from the premium received
• Caps upside at the strike price
• Max gain = (Strike price - Stock purchase price) + Premium received
• Max loss = Stock purchase price - Premium received (stock goes to $0)
• Breakeven = Stock purchase price - Premium received
• Appropriate for flat-to-slightly-bullish market outlook

Collar (long stock + long put + short call):

• Combines protective put with covered call
• Limits both upside and downside
• The short call premium offsets (partially or fully) the cost of the long put
• If premiums are equal, it is a zero-cost collar

Exam Tip: Gotchas

A protective put limits losses but still allows unlimited upside. A covered call generates income but caps the upside. The exam tests whether you know which strategy matches which client goal.

Speculation with Options

• Buying calls = speculating on price increase (bullish)
• Buying puts = speculating on price decrease (bearish)
• Options provide leverage - control a large position with a small premium
• Leverage amplifies both gains and losses
• Speculative use involves higher risk than hedging
• Maximum loss for a speculative buyer is always limited to the premium paid

American vs. European Style Options

• The terms refer to exercise timing, NOT geographic location
• Most U.S.-listed equity options are American style
• Most index options are European style and cash settled

Exam Tip: Gotchas

"American" and "European" describe WHEN an option can be exercised, not WHERE it trades. American = any time. European = only at expiration.

Exercise and Assignment

Exercise (initiated by the holder/buyer):

• Call holder exercises to buy at the strike price
• Put holder exercises to sell at the strike price
• Exercise is voluntary - the holder can let the option expire

Assignment (imposed on the writer/seller):

• The writer is obligated to fulfill the contract when assigned
• Assignment is random among all writers of that option series

Options Clearing Corporation (OCC):

• Acts as guarantor and central counterparty for all listed options
• Issues, clears, and settles all standardized options contracts
• Eliminates counterparty risk between buyer and seller

Index Options

• Based on a stock index (e.g., S&P 500)
• Cash settled - no physical delivery of securities; profit/loss paid in cash
• Used to hedge a diversified portfolio against market (systematic) risk
• Typically European style (exercised only at expiration)
• Multiplier is typically $100

Exam Tip: Gotchas

Equity options involve physical delivery of shares. Index options are always cash settled. The exam tests this distinction.

LEAPS (Long-Term Equity Anticipation Securities)

• Options with expiration dates up to 3 years in the future
• Available on individual equities and some indexes
• Provide longer-term hedging and speculation opportunities
• Higher premiums than standard options due to greater time value
• Function identically to standard options except for the longer duration

Costs, Benefits, and Risks of Options

Benefits:

• Hedging - protect existing portfolio positions
• Income generation - covered call writing produces premium income
• Leverage - control large positions with smaller capital outlay
• Flexibility - profit in rising, falling, or flat markets

Costs:

• Premium - the upfront cost paid by the buyer
• Time decay - option value erodes as expiration approaches
• Commissions - transaction costs for opening and closing positions

Risks:

• Total loss of premium for buyers if the option expires worthless
• Unlimited loss for uncovered call writers
• Opportunity cost - covered call writers forgo gains above the strike price
• Leverage risk - amplified losses for speculative positions
• Liquidity risk - some options may have wide bid-ask spreads

Exam Tip: Gotchas

Naked call writing = unlimited risk. This is the most dangerous options position. Naked put risk is NOT unlimited - the stock can only fall to zero, so maximum loss = strike price minus premium.

Warrants

• Long-term options issued by a corporation (typically 2 to 5+ years)
• Give the holder the right to buy the company's stock at a fixed exercise price
• Exercise price is typically set above the current market price at issuance
• Often issued as a sweetener attached to bonds or preferred stock to make those securities more marketable
• Exercising warrants creates new shares - dilutive to existing shareholders
• Issuance requires shareholder approval because of dilution
• Trade on exchanges or over-the-counter (OTC); have time value
• NOT issued by the OCC (unlike standardized options)

Warrants vs. Listed Options:

Exam Tip: Gotchas

Exercising a warrant creates NEW shares and dilutes existing shareholders. Exercising a listed option involves existing shares: no dilution. This is the key difference.

Rights (Preemptive Rights)

• Short-term instruments (typically expire in 30 to 90 days)
• Give existing shareholders the right to buy new shares before the public offering
• Exercise price is set below the current market price (a discount)
• Issued to protect shareholders from dilution when new shares are offered
• Each share of stock receives one right; multiple rights may be needed to buy one new share
• Also called subscription rights or preemptive rights
• Rights trade on exchanges during the subscription period

Rights vs. Warrants:

Exam Tip: Gotchas

Rights have a below-market exercise price and expire quickly. Warrants have an above-market exercise price and last for years. Both create new shares when exercised.

Futures Contracts

• Standardized contracts traded on regulated exchanges
• Obligation (not a right) to buy or sell an asset at a set price on a future date
• Both buyer and seller are obligated to perform
• Cleared through a clearinghouse that acts as counterparty to both sides
• Require margin deposits (performance bonds, not down payments)
• Subject to daily settlement (mark-to-market) - gains/losses settled each day
• Common underlying assets: commodities, stock indexes, currencies, interest rates
• Minimal counterparty risk due to clearinghouse guarantee

Margin in futures:

• Initial margin - deposit required to open a position
• Maintenance margin - minimum balance that must be maintained
• Margin call - triggered when account falls below maintenance margin; must deposit funds to restore to initial margin level
• Margin is a good-faith deposit, not a loan (unlike securities margin)

Exam Tip: Gotchas

Futures margin is a performance bond, NOT a loan. This differs from securities margin, where the broker lends money. No interest is charged on futures margin.

Forward Contracts

• Customized contracts negotiated privately between two parties
• Traded over-the-counter (OTC), NOT on an exchange
• Terms (size, delivery date, underlying asset) are fully negotiable
• No clearinghouse - each party bears counterparty risk (default risk)
• No daily settlement - settled at maturity only
• No margin requirements (historically; post-Dodd-Frank some may require)
• Used by institutions to hedge specific exposures (e.g., currency, interest rate)

Futures vs. Forwards:

Exam Tip: Gotchas

The exam loves to test the futures vs. forwards distinction. Remember: Futures = exchange, standardized, clearinghouse, daily settlement. Forwards = OTC, customized, no clearinghouse, settlement at maturity.

Suitability of Derivatives for Advisory Clients

• Derivatives are complex instruments; not suitable for all clients
• Investment advisers must assess client's risk tolerance, investment objectives, and experience before recommending
• Hedging with options may be appropriate for clients seeking to protect existing positions
• Speculative strategies are only suitable for clients with high risk tolerance, sufficient net worth, and investment experience
• Covered call writing may be appropriate for income-oriented clients in flat markets
• Uncovered (naked) options are generally unsuitable for most advisory clients
• Futures are primarily used by institutional investors and sophisticated individuals

Exam Tip: Gotchas

The Series 65 tests from the investment adviser's perspective. The question is not just "what does this derivative do?" but "is this derivative suitable for THIS client?" Always match the strategy to the client profile.