Futures and Options

Futures and Options

Derivatives — contracts whose value derives from an underlying asset — come in two major families for Series 66 purposes: options (the buyer has a right but no obligation) and futures (both parties have an obligation). The asymmetry is the single most important conceptual distinction in derivatives, driving everything from risk characteristics to suitability. The exam tests derivatives at a definitional and risk-recognition level rather than a quantitative-pricing level — you don't need Black-Scholes, but you do need to recognize what each instrument is, who has what rights and obligations, what the worst-case loss looks like, and which clients these products are suitable for. This chapter develops options first, then futures, then covers the hedging-vs-speculation framework that drives suitability analysis.

Options Definitions

The Series 66 tests options at a definitional level — you need to know what options are and basic terminology, not complex strategies.

• Call option: Gives the holder the right to buy the underlying asset at the strike price before expiration
• Put option: Gives the holder the right to sell the underlying asset at the strike price before expiration
• Premium: The price paid to purchase an option
• Strike (exercise) price: The price at which the option can be exercised
• Intrinsic value: The in-the-money amount (market price − strike for calls; strike − market price for puts)
• Time value: Premium minus intrinsic value

Futures Definitions

A futures contract is an obligation (not a right) to buy or sell a specified quantity of an asset at a set price on a future date.

• Traded on regulated exchanges (e.g., CME Group)
• Standardized contracts (quantity, quality, delivery date)
• Require margin deposits (good-faith deposits)
• Marked to market daily
• Used for hedging and speculation
• Regulated by the CFTC, not the SEC

Moneyness — ITM, ATM, OTM

The relationship between the stock's current price and the option's strike price determines the option's "moneyness." This is the single most important descriptive label applied to an option position because it tells you whether exercising would currently produce value.

Intrinsic value, time value, and the premium decomposition

The premium of an option is the price the buyer pays the writer. It decomposes into two components:

• Intrinsic value = the in-the-money amount. For calls: max(stock price − strike, 0). For puts: max(strike − stock price, 0). Cannot be negative.
• Time value = everything else. Reflects the possibility that the option will move further in-the-money before expiration. Decays toward zero as expiration approaches — this is "time decay" or theta.

Two practical implications:

• Out-of-the-money options have ZERO intrinsic value — their entire premium is time value. As expiration approaches, an OTM option's premium decays toward zero. This is why "buying lottery tickets" with OTM options usually loses money: even if the underlying moves in the right direction, the move has to be large enough and fast enough to overcome the time decay.
• Deep ITM options have very little time value — their premium is mostly intrinsic. They behave nearly like the underlying stock (with delta close to 1.00 for deep-ITM calls) but with leverage from the smaller capital outlay.

The Series 66 tests intrinsic-vs-time-value decomposition directly. Common question: an option has a premium of $4 with the underlying $2 in-the-money. Intrinsic value is $2; time value is $4 − $2 = $2.

Buyer vs. writer — rights and obligations

Every option contract has two sides: a buyer (long) and a writer (short, also called the seller). The roles are NOT symmetric — the asymmetry is the defining feature of options.

The single most-tested derivative concept on Series 66: buyers have asymmetric upside (premium-capped downside, larger upside); writers have asymmetric downside (premium-capped upside, much larger potential downside). A "naked" call writer (no offsetting stock) faces theoretically unlimited losses because the underlying can rise arbitrarily.

Long call — the "buy" position

A long call is the simplest bullish options position. The buyer pays a premium for the right to buy the underlying at the strike before expiration.

• Maximum loss = premium paid. Realized if the stock stays at or below the strike at expiration.
• Maximum gain = unlimited (theoretically). The call holder profits as the stock rises above the strike.
• Breakeven at expiration = strike + premium. Below this point, the position loses money; above it, it profits.

The long call is "leveraged exposure" to upside — a small premium controls 100 shares of underlying (one option contract = 100 shares). It's used by investors who want directional bullish exposure with capped downside.

Long put — the "sell at strike" position

A long put is the bearish counterpart to the long call. The buyer pays a premium for the right to sell the underlying at the strike before expiration. The position profits if the stock falls.

• Maximum loss = premium paid. Realized if the stock stays at or above the strike at expiration.
• Maximum gain = strike − premium. Realized if the stock goes to zero.
• Breakeven at expiration = strike − premium. Above this point, the position loses money; below it, it profits.

Note that the long put's maximum gain is bounded (the stock can't go below zero), unlike the long call's theoretically unlimited upside. Long puts are used both for bearish speculation and (more commonly in advisory contexts) as portfolio insurance — the protective put strategy.

Short call and short put — the writer's perspective

Writing (selling) options is the mirror image of buying them. The writer collects the premium up front but takes on the obligation to perform if assigned. The risk profile inverts:

The Series 66 expects you to know that naked call writing carries unlimited loss potential and is generally unsuitable for retail investors with limited net worth. Covered call writing (writing calls against shares already owned) is far safer because the worst case is having the shares called away at the strike — the underlying long stock position covers the obligation. This is the most common form of option writing in retail advisory portfolios.

Basic option strategies for the Series 66

While the Series 66 tests options at a definitional level, you should understand the two basic protective strategies that come up routinely in advisory contexts. Both are developed in more detail in the next subsections.

• Protective put (portfolio insurance). Investor owns stock + buys a put option. The put sets a floor on the stock's value — if the stock drops below the strike, the put gains value, offsetting losses. Cost: the premium paid for the put reduces overall return. Used by advisers to protect an existing stock position against downside risk.
• Covered call (income generation). Investor owns stock + sells (writes) a call option. Collects premium income but caps upside — if the stock rises above the strike, the shares are called away. Used to generate income on stocks the investor would be willing to sell at the strike price.

Protective put — portfolio insurance

A protective put combines a long stock position with a long put on the same stock. The put functions as insurance: it caps the maximum loss on the stock at the strike price, no matter how far the stock falls.

• Cost = premium paid for the put. This is the "insurance premium" the investor accepts in exchange for downside protection.
• Maximum loss = (stock cost basis − strike) + premium. Below the strike, additional stock losses are offset by put gains, dollar for dollar.
• Maximum gain = unlimited (stock upside), reduced by the put premium paid.
• Breakeven = stock cost basis + put premium. The stock must rise enough to cover the cost of the put insurance.

Protective puts are the canonical option strategy for advisory portfolios — they let clients maintain stock exposure while bounding downside. The Series 66 routinely tests recognition of the protective put as the right answer when a client has an existing stock position and wants downside protection.

Covered call — income generation with capped upside

A covered call combines a long stock position with a short (written) call on the same stock. The investor collects premium income in exchange for capping the upside — if the stock rises above the strike, the shares are called away and the investor surrenders gains above strike.

• Income = premium received for writing the call.
• Maximum gain = (strike − stock cost basis) + premium received. Upside is capped at the strike.
• Maximum loss = stock cost basis − premium received. Same downside as owning the stock outright, reduced by the premium income.
• Breakeven = stock cost basis − premium received.

Covered calls are widely used in advisory portfolios as an income strategy on stocks the investor would be willing to sell at the strike anyway. The risk is forgone upside, not unlimited loss — the long stock "covers" the call obligation.

American vs. European exercise

Options come in two exercise styles, distinguished by when the buyer can exercise:

Two practical Series 66 takeaways:

• Most U.S. equity options are American-style — individual stock options listed on CBOE, NYSE American, and similar exchanges. The "American" designation is the default for retail equity option trading.
• Major cash-settled index options are European-style — SPX, NDX, RUT. These settle in cash on the expiration date based on the index's settlement value, not by delivery of underlying shares.

The distinction matters for option strategy: American-style allows early exercise (relevant for collecting dividends on the underlying before ex-date) while European-style does not.

The Options Clearing Corporation (OCC)

The Options Clearing Corporation (OCC) is the central clearinghouse for all listed equity options in the United States. Every options trade on a U.S. exchange clears through the OCC, which becomes the counterparty to both sides of every trade.

How the OCC works:

• Trade clearing. When you buy an option, the OCC technically becomes your counterparty (and the seller's counterparty). The original counterparties never interact directly; each faces the OCC.
• Performance guarantee. The OCC guarantees that every option will be honored at exercise. If a writer defaults, the OCC steps in to perform. This eliminates counterparty risk for retail option buyers.
• Standardization. The OCC issues standardized option contracts — one contract = 100 shares of the underlying, standard strike intervals, standard expiration dates (typically the third Friday of the month).
• Margin and capital requirements. The OCC sets margin and capital requirements for clearing members to ensure they can meet their obligations.

The OCC's role is what makes the listed options market function for retail investors. Without the central clearing guarantee, every option position would carry counterparty risk — the risk that the writer can't or won't perform. The OCC eliminates that risk by interposing itself as the counterparty to every trade.

Regulation: equity options are regulated by the SEC, with the OCC operating as a SEC-registered clearing agency. Commodity and futures options are regulated by the CFTC (covered in §4).

Futures margin — initial and maintenance

Unlike stock margin (a loan to buy securities), futures margin is a good-faith deposit — performance collateral, not a loan. Both parties to a futures contract post margin to demonstrate ability to perform.

• Initial margin is posted when the contract is opened. Typically 5-15% of the notional contract value, set by the exchange.
• Maintenance margin is the minimum equity that must be maintained in the account. Typically 75-90% of initial margin.
• Margin calls occur when the account equity falls below the maintenance margin. The trader must deposit cash to bring the account back to initial margin (NOT just to maintenance — back to the full initial level).
• Failure to meet a margin call typically results in the broker liquidating the position to recover the shortfall.

The 5-15% initial margin gives futures their characteristic high leverage: a 10% margin requirement means $1 of equity controls $10 of notional exposure. A 10% adverse move in the underlying wipes out the entire equity. This is why futures are widely considered unsuitable for clients without significant net worth, liquid reserves to meet margin calls, and tolerance for total-loss-and-then-some outcomes.

Daily mark-to-market settlement

A unique feature of futures contracts is daily mark-to-market settlement: each trading day, the exchange determines an official settlement price, calculates each trader's P&L for the day, and credits or debits the trader's margin account accordingly.

How it works:

• End-of-day settlement. The exchange calculates the official settlement price (usually a weighted average of late-day trades).
• Daily P&L flows through the margin account. A trader long futures who experienced a gain has cash CREDITED to the margin account; a loss has cash DEBITED. The opposite for shorts.
• Margin calls fire immediately if the daily mark-to-market drops equity below maintenance margin. There's no waiting until expiration to settle up.
• By expiration, no P&L remains accumulated. All gains and losses have been settled through the daily mark-to-market mechanism along the way. The contract simply expires or is offset by a closing trade.

This is a major contrast with stock holdings (which only realize gains or losses on sale) and with most options (which realize P&L only at exercise or expiration, though margin requirements may be adjusted intraday for option writers). The daily mark-to-market is what keeps the futures clearinghouse safe — positions can't accumulate large unrealized losses that threaten counterparty performance, because losses are collected daily as they occur.

Hedgers vs. speculators

Both options and futures serve two fundamentally different purposes — hedging (reducing risk in an existing position) and speculating (taking on risk to profit from price movement). The distinction matters for suitability analysis.

Speculators serve a useful role in the market — they provide liquidity and absorb the risk that hedgers shed. Without speculators, hedgers couldn't easily find counterparties. The CFTC's regulatory framework explicitly recognizes both roles and requires position-limit and reporting compliance that distinguishes "commercial" (hedging) from "non-commercial" (speculative) traders.

Suitability of derivatives in advisory contexts

Derivatives sit at the high-risk end of the investment spectrum and require specific suitability analysis. The Series 66 tests suitability scenarios more often than mechanics.

Suitability considerations:

• Option-buying suitability. Buying calls or puts has bounded downside (premium) but high probability of total loss. Suitable for investors with discretionary capital they can afford to lose, sophistication to understand the instruments, and clear directional view.
• Naked option-writing suitability. Writing uncovered options exposes the writer to potentially unlimited losses (naked calls) or very large bounded losses (naked puts). Suitable only for sophisticated, high-net-worth investors with margin capacity and explicit option-writing authorization. NOT suitable for retirees, conservative investors, or anyone with limited liquid reserves.
• Covered call suitability. Covered calls have the risk profile of long stock minus capped upside. Suitable for investors holding the underlying who want income and would be content selling at the strike. Less risky than naked writing.
• Protective put suitability. Protective puts are insurance — suitable for investors with concentrated stock positions they want to protect from downside (e.g., recent IPO holders, executive stock concentrations). The cost (premium) is the insurance price.
• Futures suitability. The leverage and daily mark-to-market make futures unsuitable for most retail investors. Suitable for sophisticated traders, institutional hedgers, and high-net-worth speculators with capital cushions for margin calls. Specific NFA suitability disclosures are required for retail futures accounts.

The Series 66 favorite test scenario: a retiree on fixed income asking about a complex options strategy. Recognize that age, income needs, and conservatism point toward LESS complex products, not more.

Options vs. Futures — key distinctions side by side