Element 8 covers 6 questions on derivatives. Learn the fundamentals of calls, puts, premiums, strike prices, intrinsic value, time value, and the difference between hedging and speculation.
What is a Derivative?
A financial contract whose value is "derived" from an underlying asset (stock, index, commodity, currency, or interest rate). You don't own the asset—you own a contract based on the asset.
Options: Calls and Puts
Call Option
- Definition: The right (not obligation) to BUY the underlying at a specific price within a specific time
- Strategy: Bullish—you buy a Call if you think the price will rise
- Example: Stock at $50, buy $55 Call. If stock goes to $70, you can buy at $55 and profit
Put Option
- Definition: The right (not obligation) to SELL the underlying at a specific price within a specific time
- Strategy: Bearish/Protective—you buy a Put if you think price will fall or want to protect existing holdings
- Example: Own stock at $50, buy $45 Put. If stock crashes to $20, you can still sell at $45
Key Option Terms
Premium
- The price you pay to purchase the option contract
- Maximum loss for the buyer
- Income for the seller (writer)
- Formula: Premium = Intrinsic Value + Time Value
Strike Price (Exercise Price)
- The predetermined price at which you can buy (Call) or sell (Put)
- Fixed throughout the contract's life
- Investors choose strike based on where they think the stock is going
Intrinsic Value
The tangible value if exercised right now (the "in-the-money" portion).
- Call: Stock Price - Strike Price (if positive)
- Put: Strike Price - Stock Price (if positive)
- Cannot be less than zero
Time Value
- The portion of premium NOT intrinsic value
- Reflects probability the option will increase in value before expiry
- Time Decay (Theta): Time value erodes as expiration approaches
- At expiration, time value = zero
Option Moneyness
| Status | Call Option | Put Option |
|---|---|---|
| In-the-Money (ITM) | Stock > Strike | Stock < Strike |
| At-the-Money (ATM) | Stock = Strike | Stock = Strike |
| Out-of-the-Money (OTM) | Stock < Strike | Stock > Strike |
Hedging vs. Speculation
Hedging
- Purpose: Reduce/eliminate risk of adverse price movement (like insurance)
- Example: "Protective Put"—own 1,000 shares, buy Puts. If market crashes, Put profits offset share losses
Speculation
- Purpose: Profit from predicted price movement using leverage
- Leverage: Small premium controls large amount of stock
- Risk: Can lose 100% of premium if wrong
Futures Contracts
Definition
An agreement to buy or sell an asset at a specific future date for a specific price.
Key Differences from Options
| Feature | Options | Futures |
|---|---|---|
| Nature | Right (not obligation) | Legally binding obligation |
| Upfront Cost | Premium | Margin deposit |
| Settlement | At expiration or exercise | Daily mark-to-market |
Futures Characteristics
- Trade on exchanges (Montreal Exchange)
- Standardized terms (quantity, quality, delivery date)
- Gains and losses settled daily
- Both buyer and seller must fulfill or close out before expiry
CIRE Exam Tips for Derivatives
- Remember: Call = right to BUY, Put = right to SELL
- Buyer's maximum loss = premium paid
- Seller's (writer's) maximum loss can be unlimited (naked calls)
- Time value always erodes toward zero
- Hedging protects existing positions; speculation seeks profit from price movement
Tags:cire derivativesoptions puts callsfutures contractshedging speculation