Options and Warrants

The exam tests this unit through repeated pairs: call versus put, buyer versus writer, American versus European, warrant versus right. Master each pair and the individual definitions fall into place around them.

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 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

What's the Difference Between a Call and a Put?

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

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

What Makes an Option Standardized, and What Does the OCC Do?

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 standard equity option 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

What Are the Key Option Contract 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

How Do You Tell If an Option Is In, At, or Out of the Money?

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.

Who Has the Right, and Who Has the Obligation?

• 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.

Think of it this way: A stock's price can fall to $0, but never below. That floor is why a put's max gain (buyer) and max loss (writer) are both capped at strike price minus premium instead of growing without limit as the stock drops. At the floor, the put writer is forced to buy worthless shares at the strike price: the loss is the full strike value, offset by the premium already collected. Example: a $30 strike put written for a $2 premium has a max loss of $28, not the $20 loss at a stock price of $10. The worst case is the stock at $0, not $10.

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).
• Max loss uses the worst case ($0), not an arbitrary drop. A stock falling from $30 to $10 produces a loss at that price point, but the maximum loss formula (strike - premium) assumes the stock goes all the way to zero, the true worst case for a put writer.

How Do You Calculate Break-Even?

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.

What's the Difference Between American and 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 Do Equity and Index Options Settle?

Style (American vs. European) answers when an option can be exercised. Settlement answers what actually changes hands once it is.

• Equity options settle by physical delivery. Exercise moves the actual shares: the call holder buys 100 shares at the strike, and the put holder sells 100 shares at the strike.
• Index options settle in cash. There is no basket of stocks to deliver, so the writer pays the holder the in-the-money amount: the difference between the index level and the strike, multiplied by the contract multiplier (commonly 100).
• Cash settlement is why exercising an index option simply pays cash instead of creating a stock position.

Exam Tip: Gotchas

• Style and settlement are two separate questions that happen to line up for the most commonly tested contracts. Most U.S.-listed equity options are American style and settle in shares; most index options are European style and settle in cash. The exam most often tests the cash-settlement point by asking what an index option holder actually receives at exercise.

How Are Options 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.

Portfolio managers apply the same idea at the portfolio level: buying index puts hedges systematic (market) risk across an entire portfolio, rather than insuring one stock at a time.

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

Think of it this way: A covered call works like renting out a house you own with an option-to-buy clause attached to the lease. You collect rent (the premium) up front, whether or not the tenant ever exercises the option. If the value climbs and the tenant exercises, you must sell at the price you already agreed to, even if the house is worth more by then. If it doesn't climb that high, you simply keep the rent and the house.

Example: You own 100 shares purchased at $48. You write a $50 call for a $2 premium. If the stock stays below $50 at expiration, the call expires worthless: you keep the $200 premium and your shares. If the stock instead rises to $60, the call is exercised and you must sell at $50: your total gain is the $2-per-share rise from your $48 basis to the $50 strike, plus the $2 premium, for $400 total, even though the stock is trading at $60. The premium and the gain up to the strike are yours; the gain above $50 is not.

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.

What Are 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.

How Do Warrants Differ from 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.

What Are 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

How Do Warrants and Rights Compare?

• 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.

What Should You Check on Exam Day?

• A call is the right to buy, a put the right to sell; buyers pay premiums and hold rights, writers collect premiums and hold obligations.
• Premium = intrinsic value + time value. Only ITM options carry intrinsic value; ATM and OTM options are time value only.
• Put moneyness is the mirror image of call moneyness: a put is ITM below the strike, a call is ITM above it.
• A put writer's max loss uses the stock falling to $0, not an arbitrary drop, because a stock price cannot go negative.
• Most equity options are American style and settle by physical delivery; most index options are European style and settle in cash based on the index level, strike, and multiplier.
• A protective put is a bullish strategy: the investor wants the stock to rise but buys insurance against a drop.
• Warrants and rights are issued by the corporation, not the OCC, and both create new shares (dilutive) when exercised; exchange-traded options do not.
• Warrants run 5 to 10 years with an above-market strike; rights run 30 to 60 days with a below-market strike.