You have now covered the costs, benefits, risks, and suitability of derivatives. Here is a framework for approaching derivative characteristics questions on the exam.
Quick Reference: Costs by Derivative Type
| Derivative | Primary Cost | Margin? |
|---|---|---|
| Options (buyers) | Premium | No |
| Options (writers) | Margin (if uncovered) | Yes |
| Warrants | Premium + exercise price | No |
| Futures | Initial margin (performance bond) | Yes (daily mark-to-market) |
| Forwards | Negotiation and legal costs | No |
Quick Reference: Benefits by Derivative Type
| Derivative | Key Benefit |
|---|---|
| Options (buyers) | Leverage with defined maximum loss (premium) |
| Options (sellers) | Income generation (premium received) |
| Warrants | Long-duration leverage (2-5+ years) |
| Futures | Hedging plus liquidity plus clearinghouse guarantee |
| Forwards | Full customization with no daily margin calls |
Quick Reference: Risks by Derivative Type
| Derivative | Key Risk |
|---|---|
| Long options | Total loss of premium (wasting asset) |
| Naked call writers | Unlimited loss |
| Naked put writers | Substantial loss (strike - premium) |
| Futures | Margin calls plus leverage amplifies losses |
| Forwards | Counterparty risk (no clearinghouse) |
The Suitability Spectrum
From lowest risk to most aggressive:
- Protective puts: low risk (insurance on existing stock)
- Covered call writing: low risk (income on existing stock)
- Long calls or puts: aggressive (speculation, total premium at risk)
- Speculative futures: aggressive (repeated margin calls possible)
- Naked call writing: most aggressive (unlimited loss potential)
The Critical Exam Questions
When you see a derivative characteristics question, ask:
- What is the cost? (premium, margin, commissions)
- What is the maximum loss? (limited or unlimited)
- Who benefits from time decay? (always the seller)
- Is this suitable for the client? (match strategy to risk tolerance)
- Futures vs forwards? (exchange and clearinghouse vs over-the-counter and 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
- Naked put writing = limited risk (strike minus premium); not unlimited because the stock can only fall to zero
- Protective put preserves unlimited upside; covered call caps upside
- Forwards carry counterparty risk; futures do not (clearinghouse eliminates it)
- Futures margin is a performance bond, NOT a margin loan; no interest is charged
- The adviser's fiduciary duty governs every recommendation: legality is not the same as suitability