Two clients each say they "own a contract." One paid $450 and can lose nothing more. The other posted $2,000 and can owe cash every evening the price moves against her. Derivatives questions mostly test whether you can tell a right from an obligation.
A derivative is a contract whose value comes from an underlying asset, index, rate or commodity, such as a stock, the S&P 500, an interest rate or wheat. When the underlying moves, the derivative's price follows. Investors use derivatives to hedge a risk they already carry or to speculate with leverage. Whether a derivative is a security decides which regulator's rules apply:
- Options on securities: An option on a security is itself a security. Securities Act of 1933 Section 2(a)(1) lists "any put, call, straddle, option, or privilege on any security." The...
- Warrants and rights: Warrants and rights to buy securities are named in the Uniform Securities Act (USA) definition of security, Section 401(m).
- Commodity futures: Commodity futures are not securities. The Commodity Futures Trading Commission (CFTC) has exclusive jurisdiction over them under the Commodity Exchange Act (CEA), 7 U.S.C. 2(a)(1)(A).
Common mistakes
- Putting the obligation on the put buyer: A put buyer has the right to sell. A client who "must buy 100 shares at $40" wrote a 40 put.
- Calling out-of-the-money premium intrinsic: A 50 call at $1.20 with the stock at $47 has $0 intrinsic value and $1.20 time value. Flipping put moneyness is the twin error: a 55 put with the stock at $58 is out of the money.
- Treating futures margin like stock margin: Example 2's $30,000 contract needed a $2,000 good-faith deposit, not $15,000 under Regulation T. Its margin call was $750 back to initial, not $250 back to maintenance.
Bottom line
- An option on a security is a security under Securities Act Section 2(a)(1); warrants and rights are named in USA Section 401(m); commodity futures are not securities and fall under the CFTC.
- A call is the right to buy and a put the right to sell at the strike until expiration; the buyer pays the premium, and the writer collects it and must perform if assigned.
- Listed equity options cover 100 shares, are issued and guaranteed by the OCC, and normally expire on the third Friday; American-style exercise runs through the expiration date, European-style only on it.
- LEAPS run more than a year, commonly about three years, with Cboe rules allowing up to 180 months; index options and stock index futures settle in cash.
Exam shortcut
Read the verb. A party who "may" act holds an option; a party who "must" act is a writer or either side of a futures contract. For moneyness, ask whether you would exercise right now: buy at 50 when the stock is 53, yes; sell at 55 when it is 58, no. Compute intrinsic value first, floor it at zero, then subtract it from the premium to get time value.
The full lesson (about 3,379 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- B14
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