Foot note: Stock options are very complex. If you were preparing for the Series 7 exam we would talk about stock options and advanced strategies for 5 modules, for this exam you only need to understand the very basics.

A derivative product is a security that contractually derives its value from the performance of an underlying security. The most commonly used derivative product is an option contract. The underlying value of the security that the option is being issued on determines the value of the contract. For instance, if an investor purchases a General Electric June 50 Call Option, the option is a security, and its value is based on the performance of the underlying company, General Electric. The value of the option contract is based on General Electrics' value in the market. This explains why equity options are considered derivative securities.

Derivatives can be created for equity securities, indexes, interest rates, currencies, and a variety of other securities. Investors use derivative products for leverage and hedging purposes. Leverage allows the investor to control more of a security, and hedging protects the investor against adverse occurrences, much like an insurance policy. Derivative instruments are used by most of the major financial institutions in the world. The use of leverage and hedging allow the larger financial players to make huge profits in any type of market, whether bullish or bearish. The larger brokerages, money center banks, and other financial institutions place great emphasis on the derivative securities portions of their businesses. They use them for hedging

purposes, and to leverage their existing portfolios. Derivative securities vary extensively from put and call equity options to interest rate and currency options. Even variable annuities are a type of derivative security, since their performance depends on the performance of another security. Options began trading on organized exchanges in the early 1970’s. In a sense an option is a bet between two investors. One side of the contract believes that the market for the underlying security will increase in value above the strike price, and the other side believes the market for the underlying security will decline in value below the strike price.

There are only two types of options that are available to investors, puts and calls. When you hear terms like Spread, Straddle, Strangle, Butterfly or Combination these are not types of stock options; they are strategies that use puts and calls and they are far too deep for the exam. A call option is the right to purchase the underlying security by the holder at the predetermined strike price. The holder or buyer has purchased the right to buy the stock at the strike price. The seller or writer has sold the right to buy the underlying stock at the strike price. The buyer wants the stock to increase in value so that they may purchase the underlying security at the lower strike price. The seller wants the stock to decrease in value below the strike price, so that the option will not be exercised against them, and they will keep the entire premium earned. A put option is the right to sell the underlying security by the holder at the predetermined strike price. The holder or buyer of a put, has purchased the right to sell the underlying stock at the strike price. The seller or writer of a put option has sold the right to sell the stock at the strike price. The buyer wants the stock to decrease in value so they can sell the underlying security back to the writer at the higher strike price. The writer or seller of the put option wants the stock to increase in value above the strike price so the option will not

be exercised against them, and they will keep the entire premium earned. An option contract is broken down into various components. An understanding of each component of the option contract is necessary preparation for the exam. When an investor purchases an option contract, they have effectively gone long the option position. This is also known as the investor's opening purchase of the contract. They have created a new contract in the market, and have increased the number of open interest positions in the market by the number of contracts they have purchased. When an investor sells or writes a contract, it is known as short the option or an opening sale.

Each contract of an option represents 100 shares of the equity security that the option represents. One contract = 100 shares, 10 contracts represents 1000 shares. The Options Clearing Corporation (OCC) does set limits on the number of contracts that an investor may hold on either side of the market. The maximum is set at 25,000 contracts for the larger, more active securities. The underlying security is the actual equity security that is represented by the option contract. The OCC determines which securities have options issued on them in the market. Remember, when an investor purchases an option, they are not actually purchasing the company shares, but rather the right to buy or sell those shares at a time during the life of the contract.

The expiration month for the option contract runs as part of the option cycle. Option contracts run during one of the three option cycles. These are set as: Cycle # 1: January, April, July and October Cycle # 2: February, May, August and November Cycle # 3: March, June, September and December The current month for an option contract is known as the spot month, and all other open options are known as forward months. The actual life expectancy of an option contract at any given time is set at a maximum of nine months into the future. Thus all options except for leaps are considered short term in duration.

Option contracts expire on the first Saturday after the third Friday of the expiration month of the contract. They expire promptly at 11:59 a.m. Eastern Standard Time on that Saturday. Option contracts stop trading on the third Friday of the Expiration month at 4:10 p.m. Eastern Standard Time.

The strike, or exercise, price is the price that the contract is based on. It is set by the Options Clearing Corporation, and whether the investor is long the contract or short the contract determines whether they want the market price of the underlying security to move above or below the strike price. This is the price at which the investors involved in the contract are betting on. Call options and put options are the two types of contracts that exist. A call option gives the holder the right to buy the underlying security at the predetermined strike price. A put option gives the holder the right to sell the underlying security at the predetermined strike price.

The premium is the only component of the option contract that will change over the life of the option. The premium is set by the OCC and the Black-Scholes Option Pricing Model. The premium actually has two values. The first portion of the premium value is the intrinsic value or in the money amount of the contract. For a call option, any price above the strike price is considered to be in the money for the holder. For a put option, any price below the strike price is considered to be in the money for the holder. An option that is "out of the money" has zero intrinsic value. The second value of the premium is known as the time value. As a component of the premium, the time value is the difference between the intrinsic value and the total premium. If the premium is set at $2.00,

and the contract has $1.50 intrinsic value, then the time value would be the remaining $.50 of the premium. If the premium is set at $6.00 and the option is in the money by $4.00, then the time value would be the remaining $2.00 of the premium. The premium for the option moves in accordance with the market value of the underlying security of the option contract. Looking at a call option contract from the perspective of the holder, an increase in the market value of the underlying security above the strike price increases the premium value by the amount of the new intrinsic value.

Conversely, a decrease in the market value for the underlying security decreases the premium by a similar amount of the out of the money amount. Remember, the entire premium will not be negated even if the security price drops well below the strike price due to the time value. Even an option contract that is twenty points out of the money will still have some time value in the premium. Looking at a put option from the perspective of the holder, a decrease in the market value for the underlying security below the strike price will increase the premium value by the amount of the new intrinsic value. Conversely, an increase in the market value for the underlying security will decrease the premium by a similar amount of the out of the money amount.

Again, the put option that is twenty points out of the money will not be entirely be negated, due to time value.

Options can also be used to leverage a position for an investor. For example, an investor can purchase 100 shares of LAT stock in the market at $24 per share. To purchase the 100 shares, the investor needs to come up with $2,400. By using options as leverage, the same investor can control the same 100 shares of LAT stock by purchasing one call option contract for a price of…oh let’s just say $2 per share (the price is irrelevant for this example). This purchase would have the following notation: Buy 1 LAT Mar 25 Call @ 2 If the same investor were totally confident in an increase in the price of LAT stock, they can effectively control the same 100-

share position for only the $200 premium paid for the call option contract. Instead of purchasing the 100 shares of LAT stock for $2,400, the investor can control 1,200 shares of LAT stock for the same amount of $2,400 by purchasing 12 LAT call options at $2.00 Using option contracts as a hedge is a little different. A hedge is basically the use of a derivative security to attain protection against what the investor does not wish to see happen. In other words, if the investor does not want to see a stock decline in value, he uses an option contract (put) to protect against the possible decline in the security. If the undesired outcome occurs, the investor has hedged their position by using a derivative to offset their loss.

Example: Customer owns 100 shares of LAT stock at $30 per share Customer purchases 1 LAT October 25 put @ $1 in the market The hedge is the LAT put option that protects the investor against further loss in the event LAT stock declines in value in the market. If the stock drops in value to $10, the investor has lost $20 per share on the long position he holds. The investor will offset that loss by making back $15 on the LAT October 25 put option he used as a hedge. The net loss is now only $500 plus the $100 premium that was paid, instead of the

$2,000 loss on the long position, that otherwise would have occurred. The breakeven point is established at $31 for the stock. If the security increases in price to $31, the investor has recouped the $100 premium paid for the put option contract.