Derivatives basics and the CFA

Published on August 31, 2020   10 min
Hello, I'm Professor Michael McDonald, and today I'd like to talk to you about derivatives. Specifically, I want to talk about the areas of derivatives that you need to focus on if you're going to take the CFA exam. So let's get started. Shall we?
To begin with, when we talk about derivatives, it's important to understand that a derivative is simply any kind of financial instrument that derives its value from some other asset. For instance, common types of derivatives include options, warrants, futures, things like that. Now, when it comes to the products that most individual investors use out there, options are probably the most used product compared to something like futures or warrants. But the futures market is very, very big, especially among institutional investors as well. Nevertheless, let's take a look at what options look like in the real world.
This is a screenshot from an actual options quote, and what you're going to see here is that we have two different types of options that are out there. We have calls and we have puts. Calls give you the opportunity, but not the obligation to buy a particular stock, at a particular point in time, at a given price. Puts in contrast, give you the opportunity to sell a particular stock at a particular point in time. So calls and puts are opposites of one another, but each of them gives you the right, not the obligation to do something. For that reason, they are really valuable to investors who think that a stock might move pretty far in one direction or the other. That is, might go up a lot or it might go down a lot, but they're not certain about it. If we knew, if we were convinced that a stock would go up, we'd just buy the underlying stock. But if we're not sure then we can buy a call and then that gives us the right to profit from upside, but if the stock happens to go down instead, well, all we've done is lose a little bit of premium we paid for that call up front. That's the basic idea. Now, options is based on a few different factors, but two of the critical factors are the time to expiration and the strike price. The time to expiration is how long we have until we're going to exercise that option. In other words, what period of time do we have before we have to decide, yes, I want to do this or no, I don't. After you hit that expiration date, the option expires and you can no longer use it. In this particular case, these options that we're looking at have an expiration date of January 15th of 2021. The basic idea here is that we have up until that point to decide whether or not we'd like to exercise that option. The longer the time-frame that we have, the more expensive the option will be. If we only have, say a week from now to decide whether we want to buy or sell a particular stock, that's not very useful compared to if we have a year or two years or five years. That's the idea. Now the second critical feature of options is the strike price. The strike price tells us the price at which we've agreed in advance, we can buy or sell a particular stock.