Options and Derivatives

Options are derivative securities--their value is derived from an underlying asset such as stocks, indexes, or commodities. Understanding options is essential for the CFP exam, as they are used for hedging, income generation, and speculation.

Options Basics

An option contract is an agreement between two parties that gives the buyer specific rights regarding an underlying asset.

Key Components of Every Option Contract:

• Underlying asset: The security (stock, index, ETF) the option controls
• Strike price (exercise price): The price at which the holder can buy or sell the underlying
• Expiration date: When the option contract expires
• Premium: The price paid by the buyer to the seller for the option rights
• Contract size: Standard equity options control 100 shares

Call Options vs. Put Options

Memory device: "Call up, Put down"--call buyers want prices to go UP; put buyers want prices to go DOWN.

The Two Sides of Every Option Trade

CFP Exam Tip: Option BUYERS have limited risk (premium paid). Naked option SELLERS have potentially unlimited risk (especially short calls).

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Option Valuation: Intrinsic Value and Time Value

The option premium (market price) consists of two components:

Option Premium = Intrinsic Value + Time Value

Intrinsic Value

Intrinsic value is the profit if the option were exercised immediately. It can never be negative.

Call Option Intrinsic Value = Stock Price - Strike Price (if positive; otherwise zero)

Put Option Intrinsic Value = Strike Price - Stock Price (if positive; otherwise zero)

Time Value

Time value represents the potential for the option to gain additional value before expiration. It decreases as expiration approaches (time decay).

Time Value = Premium - Intrinsic Value

In-the-Money, At-the-Money, Out-of-the-Money

Example - Call Option:

• Stock trading at $53, Strike price $50, Premium $5
• Intrinsic value = $53 - $50 = $3 (in-the-money)
• Time value = $5 - $3 = $2

Example - Put Option:

• Stock trading at $40, Strike price $50, Premium $13
• Intrinsic value = $50 - $40 = $10 (in-the-money)
• Time value = $13 - $10 = $3

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Common Option Strategies

Covered Call

A covered call involves owning the underlying stock and writing (selling) a call option against it.

Purpose: Generate income on existing stock positions

Setup:

• Own 100 shares of stock
• Sell 1 call option (covers the stock position)

Payoff Profile:

• Maximum profit: Strike price - purchase price + premium received
• Maximum loss: Purchase price - premium received (if stock goes to zero)
• Breakeven: Stock purchase price - premium received

Trade-off: The premium received provides downside cushion, but upside gains are capped at the strike price.

Example: You own 100 shares of XYZ at $50 and sell a $55 call for $3.

• If stock rises to $60: You must sell at $55. Profit = ($55 - $50) + $3 = $8/share
• If stock falls to $45: You keep the stock. Loss = ($50 - $45) - $3 = $2/share
• Breakeven: $50 - $3 = $47

Protective Put

A protective put involves owning stock and buying a put option to protect against downside risk.

Purpose: Insurance against stock decline while maintaining upside potential

Setup:

• Own 100 shares of stock
• Buy 1 put option at desired protection level

Payoff Profile:

• Maximum profit: Unlimited (stock appreciation minus put premium)
• Maximum loss: Stock price - strike price + premium paid
• Breakeven: Stock purchase price + premium paid

Trade-off: The put premium is an insurance cost that reduces overall returns if protection is not needed.

Example: You own 100 shares of XYZ at $50 and buy a $45 put for $2.

• If stock rises to $60: Put expires worthless. Profit = $10 - $2 = $8/share
• If stock falls to $35: Exercise put at $45. Loss = ($50 - $45) + $2 = $7/share
• Breakeven: $50 + $2 = $52

Collar

A collar combines covered call and protective put strategies.

Setup:

• Own 100 shares of stock
• Buy a put option (downside protection)
• Sell a call option (premium offsets put cost)

Purpose: Low-cost or zero-cost downside protection (call premium pays for put)

Trade-off: Both upside and downside are limited.

Straddle

A straddle involves buying or selling both a call and put with the same strike price and expiration.

Long Straddle (buy call + buy put):

• Expectation: High volatility, price will move significantly in either direction
• Maximum profit: Unlimited
• Maximum loss: Total premiums paid

Short Straddle (sell call + sell put):

• Expectation: Low volatility, price will stay near strike
• Maximum profit: Total premiums received
• Maximum loss: Unlimited

Spreads

Spreads involve buying and selling options of the same type but with different strikes or expirations.

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The Option Greeks

The Greeks measure various sensitivities of option prices to different factors. Understanding Greeks helps manage option portfolio risk.

Delta (Price Sensitivity)

Delta measures how much the option price changes when the underlying stock price changes by $1.

Delta characteristics:

• ATM options have delta near 0.50 (calls) or -0.50 (puts)
• Deep ITM options approach delta of 1 (calls) or -1 (puts)
• Deep OTM options have delta near zero

Example: A call with delta of 0.60 will increase by $0.60 if the stock rises $1.

Gamma (Delta Change Rate)

Gamma measures how fast delta changes as the underlying price moves.

• Highest for ATM options near expiration
• Low for deep ITM or OTM options
• Important for hedging delta-neutral positions

Theta (Time Decay)

Theta measures how much value an option loses per day as expiration approaches.

• Long options: Negative theta (time works against you)
• Short options: Positive theta (time works for you)
• Theta accelerates as expiration approaches (especially for ATM options)

CFP Exam Tip: Theta is the enemy of option buyers and the friend of option sellers. Options lose value every day from time decay, even if the stock price doesn't move.

Vega (Volatility Sensitivity)

Vega measures how much the option price changes when implied volatility changes by 1%.

• Long options: Positive vega (benefit from rising volatility)
• Short options: Negative vega (benefit from falling volatility)
• Highest for ATM options with longer time to expiration

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Option Pricing Models

Black-Scholes Model

The Black-Scholes model calculates the theoretical value of CALL options based on five factors:

CFP Exam Tip: All factors have a direct relationship with call prices EXCEPT strike price (inverse relationship). Higher strike = lower call premium because the call is less valuable.

Put-Call Parity

Put-Call Parity defines the relationship between call and put prices for European options with the same strike and expiration. This concept ensures no arbitrage opportunity exists.

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Futures Contracts

Futures contracts are similar to options but with one critical difference: they OBLIGATE (not just give the right to) both parties to complete the transaction.

Options vs. Futures

Hedging with Futures

Position 1 - Long the commodity, Short the futures contract:

• Example: Farmer owns crops, sells futures to lock in price
• Protects against falling commodity prices

Position 2 - Short the commodity, Long the futures contract:

• Example: Manufacturer needs raw materials, buys futures
• Protects against rising commodity prices

Example: A farmer expects to harvest wheat in 6 months. Current wheat futures for that delivery date are $5.00/bushel.

• The farmer sells futures at $5.00 to lock in the selling price
• If wheat falls to $4.00 at harvest: Farmer gains on futures ($1.00/bushel), offsetting lower cash price
• If wheat rises to $6.00 at harvest: Farmer loses on futures ($1.00/bushel) but receives higher cash price
• Either way, effective price is $5.00/bushel

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Warrants

Warrants are long-term options issued by corporations to buy their own stock.

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Portfolio Insurance

Portfolio insurance uses put options on market indexes to protect a diversified portfolio from market declines.

• Buy put options on S&P 500 or other broad index
• Protection level determined by strike price chosen
• Cost of protection is the put premium

This strategy is similar to protective puts on individual stocks but protects an entire diversified portfolio from systematic market risk.