Derivative Securities

The whole unit on one sheet: options, warrants, rights, futures, and forwards, plus the buyer-versus-writer and futures-versus-forwards lines the exam loves.

The One-Liners That Win Points

• A derivative has no independent value; its worth is derived entirely from an underlying asset (stock, currency, commodity, interest rate, or index).
• Call option: right to buy 100 shares at the strike price; bullish outlook.
• Put option: right to sell 100 shares at the strike price; bearish outlook.
• Buyers hold rights (can choose to exercise); writers (sellers) hold obligations (must perform if exercised). Only the buyer can exercise.
• The Options Clearing Corporation (OCC) issues, standardizes, and guarantees all listed options, acting as counterparty and eliminating counterparty risk.
• Only in-the-money (ITM) options have intrinsic value; out-of-the-money and at-the-money options carry time value only.
• Warrants are long-term rights issued by the corporation to buy its stock; rights are short-term preemptive rights issued to existing shareholders. Both are dilutive (new shares) when exercised.
• Futures and forwards obligate BOTH parties; there is no walking away.
• Futures are standardized, exchange-traded, and cleared; forwards are private, customizable over-the-counter (OTC) deals with counterparty risk.
• Futures margin is a performance bond, not a loan; no interest is charged.
• Futures are regulated by the Commodity Futures Trading Corporation (CFTC), not the Securities and Exchange Commission (SEC); futures are not securities.

Numbers to Lock In

Memory Aid: Direction and Timing Cues

• "Call up, put down." Buy a call when expecting prices to rise; buy a put when expecting prices to fall. It also sets the break-evens: call ADDS the premium to the strike, put SUBTRACTS it.
• "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.

Top Gotchas

• A put is the right to SELL, not buy. "The owner of a put has the obligation to purchase" is false twice over: it is a right, not an obligation, and it is to sell, not buy.
• Put in-the-money is the reverse of a call. A put is ITM when market price is BELOW strike; a call is ITM when market price is ABOVE strike.
• A protective put (long stock + long put) is a bullish strategy; the investor wants the stock up but buys insurance in case it drops.
• When options are exercised, existing shares change hands (no dilution). When rights or warrants are exercised, the corporation issues NEW shares (dilutive).
• Warrants create dilution; rights protect against it by letting existing shareholders buy first.
• A futures margin call restores the INITIAL margin level, not the maintenance level; the top-up is called variation margin.
• Futures eliminate counterparty risk; forwards do not. The clearinghouse is the difference. A "customized, privately negotiated agreement" is a forward.

One-Breath Recap

A derivative draws its value from an underlying asset. A call is the right to buy 100 shares and a put the right to sell, with buyers holding rights and writers holding obligations, all issued and guaranteed by the Options Clearing Corporation, which erases counterparty risk. Only in-the-money options have intrinsic value, and "call up, put down" fixes both direction and break-even. The corporation itself issues rights (short-term, below-market, anti-dilution) and warrants (long-term, above-market, a bond sweetener), both dilutive when exercised. Futures and forwards obligate both parties: futures are standardized, exchange-traded, cleared, and carry a performance-bond margin restored to the initial level, while forwards are private, customizable, and stuck with counterparty risk.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Derivative Securities unit for the complete lesson.