Derivative Characteristics: Synthesis

You have now covered the characteristics of each major derivative type. Here is a framework for approaching derivative characteristics questions on the exam.

Quick Reference: Option Premium

  • Premium = Intrinsic Value + Time Value
  • Intrinsic value = amount in-the-money (never negative)
  • Time value = Premium - Intrinsic value (decays to zero at expiration)
  • Higher volatility and more time to expiration both increase premium

Quick Reference: Moneyness

StatusCallPut
In-the-moneyMarket > StrikeMarket < Strike
At-the-moneyMarket = StrikeMarket = Strike
Out-of-the-moneyMarket < StrikeMarket > Strike
  • Only in-the-money (ITM) options have intrinsic value
  • At-the-money (ATM) and out-of-the-money (OTM) options expire worthless

Quick Reference: Max Gain/Loss

PositionMax GainMax LossBreakeven
Long callUnlimitedPremiumStrike + Premium
Short call (naked)PremiumUnlimitedStrike + Premium
Long putStrike - PremiumPremiumStrike - Premium
Short putPremiumStrike - PremiumStrike - Premium

Quick Reference: Hedging Strategies

StrategyComponentsOutlookKey Feature
Protective putLong stock + Long putBullish with insuranceUnlimited upside, limited downside
Covered callLong stock + Short callFlat to slightly bullishIncome generation, caps upside
CollarLong stock + Long put + Short callNeutralLimits both upside and downside

Quick Reference: American vs. European

  • American = exercise any time (equity options)
  • European = exercise only at expiration (index options, cash settled)
  • The terms refer to exercise timing, NOT geography

Quick Reference: Exercise, Assignment, and OCC

  • Exercise = buyer's right (voluntary)
  • Assignment = seller's obligation (random)
  • Options Clearing Corporation (OCC) = guarantor of all listed options; eliminates counterparty risk

Quick Reference: Index Options and LEAPS

  • Index options: Cash settled, typically European style, $100 multiplier, hedge portfolio risk
  • Long-Term Equity Anticipation Securities (LEAPS): Options expiring up to 3 years out; higher premiums due to greater time value

Quick Reference: Costs

DerivativePrimary CostMargin?
Options (buyers)PremiumNo
Options (writers)Margin (if uncovered)Yes
WarrantsPremium + exercise priceNo
FuturesInitial margin (performance bond)Yes (daily mark-to-market)
ForwardsNegotiation/legal costsNo

Quick Reference: Key Benefits

DerivativeKey Benefit
Options (buyers)Leverage with defined maximum loss (premium)
Options (sellers)Income generation (premium received)
WarrantsLong-duration leverage (2-5+ years)
FuturesHedging + liquidity + clearinghouse guarantee
ForwardsFull customization + no margin calls

Quick Reference: Key Risks

DerivativeKey Risk
Long optionsTotal loss of premium (wasting asset)
Naked call writersUnlimited loss
Naked put writersSubstantial loss (strike - premium)
FuturesMargin calls + leverage amplifies losses
ForwardsCounterparty risk (no clearinghouse)

Quick Reference: Warrants vs. Rights

FeatureWarrantsRights
Duration2-5+ years30-90 days
Exercise priceAbove marketBelow market (discount)
PurposeSweetener for bond/preferred offeringsAnti-dilution for existing shareholders
Dilutive?Yes (new shares)Yes (new shares)

The Suitability Spectrum

From lowest risk to most aggressive:

  1. Protective puts - low-risk (insurance on existing stock)
  2. Covered call writing - low-risk (income on existing stock)
  3. Long calls/puts - aggressive (speculation, total premium at risk)
  4. Speculative futures - aggressive (repeated margin calls possible)
  5. Naked call writing - most aggressive (unlimited loss potential)

The Critical Exam Questions

When you see a derivative characteristics question, ask:

  1. What are the costs? (premium, margin, commissions)
  2. What is the maximum gain/loss? (limited or unlimited)
  3. Who benefits from time decay? (always the seller)
  4. Is this suitable for the client? (match strategy to risk tolerance)
  5. Futures vs. forwards? (exchange/clearinghouse vs. over-the-counter/counterparty risk)

Common Exam Gotchas

  • Time decay always works against the option buyer; the seller always benefits from time passing
  • Naked call writing = unlimited risk; the most dangerous options position
  • Breakeven is the same formula for buyer and seller of the same option type
  • Protective put = unlimited upside; Covered call = caps upside
  • Collar = protective put + covered call combined
  • American = exercise any time; European = exercise only at expiration (not geography)
  • OCC guarantees all listed options; eliminates counterparty risk
  • Index options are cash settled; equity options involve physical delivery
  • Warrants create new shares (dilutive); listed options do not
  • Rights have below-market exercise price; warrants have above-market exercise price
  • Forwards have counterparty risk; futures do not (clearinghouse eliminates it)
  • Futures margin is a performance bond, NOT a margin loan; no interest is charged