Derivative Securities

The whole unit on one sheet: options, futures, forwards, and the costs, benefits, and risks the Series 66 loves to test at a conceptual level.

The One-Liners That Win Points

• The buyer has a right; the seller (writer) has an obligation. Reversing these roles is the classic option trap.
• Option buyers can never lose more than the premium paid. Buyers have limited loss and large potential gains; sellers have limited gains (the premium) and potentially large losses.
• A short (uncovered) call writer faces unlimited loss because there is no ceiling on how high a stock can rise.
• "Covered" means the writer owns the underlying stock, so a covered call is less risky than a naked call.
• In options, only the seller is obligated. In futures, both buyer and seller are obligated.
• Futures margin is a good-faith performance deposit, not a loan like stock margin.
• Mark-to-market means daily settlement; futures do not wait until expiration.
• A futures margin call must restore the account to the initial margin level, not just the maintenance level; the required deposit is called variation margin.
• "OTC" means forwards. A privately negotiated derivative with custom terms is a forward contract.
• Time decay hurts buyers and helps sellers.

Options: Calls, Puts, and the Four Positions

• Call = right to buy at the strike price; the buyer is bullish.
• Put = right to sell at the strike price; the buyer is bearish.
• Premium is the buyer's maximum loss; strike (exercise) price is the predetermined buy/sell price; after expiration the contract is worthless.

• Call buyer profits when market price rises above strike price + premium.
• Put buyer profits when market price falls below strike price - premium.
• Protective put (own stock, buy a put) = downside insurance; covered call (own stock, sell a call) = income that caps the upside.
• Options are used for hedging, speculation (small outlay, but leverage cuts both ways), and income generation.

Futures vs. Forwards

• Both parties are obligated in a futures contract; the clearinghouse acts as counterparty to both sides, virtually eliminating counterparty risk.
• Futures cover commodities, financial instruments, stock indexes, and currencies.
• The biggest futures-vs-forwards difference is counterparty risk; forwards also carry illiquidity (hard to exit early) and no daily settlement, so losses can accumulate until the settlement date.

Costs, Benefits, and Risks

• Benefits: leverage (control a large position with a small deposit), hedging (transfer risk to a willing counterparty), flexibility (profit in rising or falling markets, define max risk upfront).
• Risks: leverage risk, time decay, liquidity risk, counterparty risk, and complexity.
• Losses can exceed the initial investment for futures and short options, unlike buying stock or long options where loss is capped at the amount paid.
• Options are wasting assets; time decay accelerates in the final 30 days before expiration.
• Costs: option premiums, commissions, margin interest, and bid-ask spreads (an implicit cost on every trade).
• Suitability: derivatives are generally unsuitable for unsophisticated or risk-averse investors seeking capital preservation.

Top Gotchas

• Leverage is both a benefit AND a risk; the exam may frame the same feature either way depending on context.
• A margin call requires restoring to the initial margin level, not the maintenance level; a common wrong answer stops at maintenance.
• Futures margin is not borrowing; it is a performance deposit, so do not confuse it with a stock margin loan.
• Series 66 tests derivatives conceptually (definitions, uses, costs, benefits, risks), not complex multi-leg strategies.

One-Breath Recap

A derivative gets its value from an underlying asset, and options are the most tested: the buyer pays a premium (the max loss) for a right, while the seller (writer) takes on the obligation, with a call betting the price rises and a put betting it falls. Futures obligate both parties, are standardized and exchange-traded, settle daily by mark-to-market, and lean on a clearinghouse that nearly erases counterparty risk (a margin call restores the initial margin level via variation margin, and margin is a deposit, not a loan). Forwards are the customized OTC version, so they carry higher counterparty risk, low liquidity, and settlement only at expiration. Across all of them, leverage cuts both ways, losses on futures and short options can exceed the investment, time decay hurts buyers and helps sellers, and derivatives suit sophisticated hedgers far more than risk-averse investors. Know the definitions, uses, costs, benefits, and risks, and this conceptual unit answers itself.

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.