Options and Warrants

Options and warrants are derivative instruments that give the holder the right, but not the obligation, to buy or sell an underlying security at a fixed price. This section covers the structure, terminology, and exam-tested distinctions for both.

What is a Derivative?

A derivative has no independent value. Its worth comes entirely from the value of something else, called the underlying asset.

Think of it this way: A stock certificate represents ownership in a company. It has value because the company has value. But an option on that stock? It only has value because of what the stock is worth. Without the underlying stock, the option would be worthless. The option's value is "derived" from the stock, hence the name "derivative."

Common underlying assets:

• Securities: Common stock (equity options)
• Currencies: Foreign exchange
• Commodities: Wheat, corn, oil, gold
• Interest rates: Treasury bonds
• Indexes: S&P 500, Dow Jones

Call and Put Options

There are only two types of options: calls and puts.

• Call option: Right to buy 100 shares at the strike price. Bullish outlook (expects price to rise).
• Put option: Right to sell 100 shares at the strike price. Bearish outlook (expects price to fall).

Memory Aid: "Call up, put down." Buy a call when expecting prices to go up. Buy a put when expecting prices to go down.

Standardized Options and the OCC

The exam focuses on standardized options traded on exchanges. These options are issued and guaranteed by the Options Clearing Corporation (OCC).

The OCC's role:

• The central clearinghouse for all U.S. listed options
• Acts as the guarantor and counterparty to every options trade
• Issues and standardizes all listed option contracts
• Handles exercise and assignment: when a holder exercises, the OCC randomly assigns an obligation to a writer
• Eliminates counterparty risk between option buyers and sellers

Three standardized terms:

• Underlying asset: Each contract covers 100 shares
• Expiration date: All options expiring in the same month share the same date (third Friday of expiration month)
• Strike (exercise) price: Set at standardized intervals

Key Terms

• Strike price: Fixed price at which the option can be exercised, regardless of market price
• Premium: Cost paid by buyer to writer; equals intrinsic value + time value
• Intrinsic value: In-the-money amount (call: market - strike; put: strike - market, when positive)
• Time value: Premium beyond intrinsic value; erodes as expiration approaches (called time decay or theta)
• Expiration: Last date option can be exercised; equity options expire the third Friday of expiration month

Moneyness

Moneyness describes the relationship between the market price and the strike price. This is frequently tested.

• Only ITM options have intrinsic value
• OTM and ATM options have time value only
• At expiration, only ITM options are exercised

Exam Tip: Gotchas

• Put in-the-money is the reverse of calls. A put is in the money when market price is BELOW strike. The exam will try to confuse you by applying call logic to puts.

Buyers vs. Writers: Rights, Obligations, and Max Gain/Loss

• Option buyers have rights (can choose whether to exercise)
• Option sellers (writers) have obligations (must perform if buyer exercises)

Only the buyer can exercise an option. The seller must perform if exercised.

Think of it this way: When you buy an option, you pay for a right, but never an obligation. You can walk away and just lose your premium. But when you sell an option, you have made a promise. If the buyer wants to exercise, you must deliver (for calls) or buy (for puts), no matter how unfavorable the price.

Exam Tip: Gotchas

• A put gives the right to sell, not buy. The exam will try to confuse you: "An owner of a put has the obligation to purchase..." is false on two counts (it is a right, not obligation, and it is to sell, not purchase).
• Only buyers can exercise options. Sellers (writers) have obligations, not rights. If the question asks "who can exercise," it is always the long position (buyer/holder/owner).

Break-Even Formulas

Memory Aid: "Call up, put down." Call break-even adds the premium to the strike. Put break-even subtracts the premium from the strike.

The breakeven is the same for both buyer and seller of the same contract; it is the price at which neither side profits.

Example: You buy a call with a $50 strike for a $3 premium. Your break-even is $50 + $3 = $53. The stock must rise above $53 for you to profit.

American vs. European Style

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

How Options Are Used

Protective put (hedging):

Own stock + buy put = puts a floor on losses; acts as insurance.

• Max loss = (stock purchase price - strike price) + premium paid
• The investor keeps all upside above the stock purchase price (minus the cost of the put)

Think of it this way: A protective put works like insurance on a house. You pay a premium (the put cost) and in return, you are protected if the value drops below a certain level (the strike price). You hope you never need it, but it limits your downside.

Covered call (income):

Own stock + write call = earns premium income; caps upside above strike price.

• "Covered" means the writer already owns shares, eliminating the unlimited-loss risk of a naked call
• The writer keeps the premium regardless of outcome

Portfolio managers use index puts to hedge systematic (market) risk across an entire portfolio.

Speculation:

• Buy call = bullish bet (profit if stock rises above strike + premium)
• Buy put = bearish bet (profit if stock falls below strike - premium)
• Max loss for buyers = premium paid
• Leverage amplifies both gains and losses; a small premium controls a large position

Exam Tip: Gotchas

• A protective put (long stock + long put) is a bullish strategy. The investor wants the stock to go up but buys insurance in case it drops. The exam tests market outlook for combined positions.

Warrants

Warrants are long-term rights issued directly by the corporation to purchase the company's common stock at a specified price before expiration.

Warrant characteristics:

• Expiration: Typically 5 to 10 years (much longer than standard options)
• Issued by: The corporation itself (not the OCC or third-party investors)
• Dilutive: When exercised, the company issues new shares (dilutive to existing shareholders)
• Purpose: Frequently attached to bond or preferred stock offerings as a "sweetener" to attract investors
• Exercise price: Above current market price at issuance
• Value at issuance: Time value only (no intrinsic value, since strike is above market)
• Trading: Traded on exchanges or over the counter (OTC)

Think of it this way: Companies often attach warrants to bond offerings as a sweetener. The bond buyer thinks: "Even if the stock is at $40 now and the warrant lets me buy at $45, if the stock rises to $60 over the next five years, I can buy at $45 and make $15 per share." This added potential makes the bond more attractive.

Warrants vs. Exchange-Traded Options

Exam Tip: Gotchas

• When options are exercised, existing shares change hands. When rights or warrants are exercised, new shares are issued. This is a key distinction.

Rights (Subscription Rights / Preemptive Rights)

Rights are short-term instruments issued by a corporation to existing shareholders when the company plans to issue additional shares.

• Give shareholders the right to purchase new shares before they are offered to the public
• Exercise price is set below the current market price (immediate intrinsic value)
• Very short-lived: typically expire in 30 to 60 days
• Protect shareholders from dilution of ownership and voting power
• When exercised, the company issues new shares (dilutive)
• Can be traded on exchanges or OTC

Warrants vs. Rights

• Both are dilutive if exercised (new shares are issued)
• Both are issued by the corporation (not the OCC)

Exam Tip: Gotchas

• Rights = Right now; Warrants = Wait for it. Rights are short-term with below-market exercise prices. Warrants are long-term with above-market exercise prices.
• Warrants create dilution; they do not protect against it (unlike rights, which protect existing shareholders by letting them buy first).