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.

Which One-Liners 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 (standard equity option) at the strike price; bullish outlook.
• Put option: right to sell 100 shares (standard equity option) 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.
• Equity options settle by physical delivery (shares change hands); index options settle in cash, paying the in-the-money amount (index level minus strike for a call, strike minus index level for a put) times the multiplier, commonly 100.
• 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 not securities, so they fall under Commodity Futures Trading Commission (CFTC) jurisdiction; the CFTC has exclusive jurisdiction over the futures contract itself, and the SEC does not regulate the futures contract.

Which Numbers Matter Most?

What Is the Memory Aid for 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.

Which Gotchas Trip Students Up?

• 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.
• Style and settlement are separate questions that just happen to line up. Most equity options are American style and settle in shares; most index options are European style and settle in cash.
• 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 standard equity option is the right to buy (call) or sell (put) 100 shares, 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, "call up, put down" fixes both direction and break-even, equity options settle in shares while index options settle in cash, and 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? Read the full Derivative Securities unit.