Suitability questions on derivatives are relatively rare on the Series 66 exam. Although options aren’t specifically listed in NASAA’s exam outline, you could still see recommendation-based questions that involve them. If they appear at all, expect only a few. As noted at the beginning of the derivatives section, plan your study time accordingly.
In general, derivatives are not suitable for most investors. Think back to how many strategies we covered that involve unlimited or significant risk. Even when the maximum loss is limited to the premium, losing 100% of that premium is still a meaningful risk.
That said, some option strategies can be appropriate for conservative or risk-averse investors when they’re used to reduce risk or generate modest income.
We’ll break down derivative suitability by strategy type:
When an investor goes long a call or long a put as their only option position, they’re typically seeking growth (capital gains/appreciation). Growth means buying at a lower price and selling at a higher price. Because these positions depend on correctly predicting short-term price movement, they’re often described as speculative.
Here’s how a long call can produce capital gains:
An investor purchases 3 long XYZ Sep 80 calls at $5 when the market price is $79. The market price rises to $120, the contracts are exercised, and the shares are liquidated in the market.
Can you figure out the overall gain or loss?
Answer = $10,500 gain
| Action | Result |
|---|---|
| Buy calls | -$1,500 ($500 x 3 contracts) |
| Exercise calls | -$24,000 ($80 x 300 shares) |
| Liquidate shares | +$36,000 ($120 x 300 shares) |
| Total | +$10,500 |
The investor is long 3 call options, which gives them the right to buy 300 shares at $80 per share. Each contract costs $5 per share.
When the market price rises to $120, the calls have $40 of intrinsic value ($120 − $80). By exercising, the investor buys 300 shares at $80 and then sells them at $120, creating a $40 per share stock gain. After subtracting the $5 premium, the net gain is $35 per share.
In that example, the investor needed the stock to rise (long calls are bullish). If the market price stayed below $80, the options would expire worthless and the investor would lose the entire $1,500 premium. Even though the maximum loss is limited to the premium, the premium can still go to zero quickly. That’s why long calls are generally suitable only for aggressive investors with high risk tolerance.
Now let’s see how a long put can produce growth:
An investor goes long 2 MNO Feb 110 puts at $3 when the market price is $114. The market price declines to $85, the investor purchases 200 shares at the market price, and exercises the option.
What is the overall gain or loss?
Answer = $4,400 gain
| Action | Result |
|---|---|
| Buy puts | -$600 ($300 x 2 contracts) |
| Buy shares | -$17,000 ($85 x 200 shares) |
| Exercise put | +$22,000 ($110 x 200 shares) |
| Total | +$4,400 |
The investor is long 2 put options, which gives them the right to sell 200 shares at $110 per share. Each contract costs $3 per share.
When the market price falls to $85, the puts have $25 of intrinsic value ($110 − $85). The investor buys 200 shares at $85 and then exercises the puts to sell those shares at $110, creating a $25 per share stock gain. After subtracting the $3 premium, the net gain is $22 per share.
In that example, the investor needed the stock to fall (long puts are bearish). If the market price stayed above $110, the puts would expire worthless and the investor would lose the entire $600 premium. For the same reason as long calls, long puts are generally suitable only for aggressive investors who can tolerate losing the full premium.
Let’s summarize the suitability of long option strategies:
When an investor goes short a call or short a put as their only option position, they’re typically seeking income. Like long options, these positions are speculative. They’re also much riskier when they’re uncovered (naked), which is the assumption in this section.
When an investor sells an option, they receive the premium immediately. That immediate premium is the appeal of selling options for income.
The tradeoff is risk:
Most income-focused investors look to instruments like bonds and preferred stock, where the risk profile is typically more controlled. Uncovered option writing doesn’t fit that pattern, so it’s generally appropriate only for aggressive investors with very high risk tolerance.
Let’s summarize the suitability of short naked option strategies:
Unlike the speculative strategies above, hedging strategies are designed to reduce risk. Two key hedging strategies are:
These positions work much like insurance. You pay a premium, and in return you limit the damage from an adverse move in the stock.
A key limitation is time: options expire (often within 9 months or less). Continuously paying premiums over long periods can reduce overall returns, even if the hedge is effective.
Index options can also hedge an entire portfolio, including mutual funds. For example, a manager of a large-cap stock fund could buy S&P 500 puts to help offset losses during a broad market decline.
Ultimately, hedging suitability depends on the underlying position being protected. The premium may reduce profits, but it can also prevent large losses.
Let’s summarize the suitability of hedging strategies:
Income strategies involve selling an option against a stock position. Two key income strategies are:
Covered calls and covered puts are most appropriate for investors with a long-term view on the stock but an expectation of a flat (neutral) market in the short term.
For example, assume an investor owns 100 shares at $75. They expect the stock to rise over the next several years, but they don’t expect it to rise above $80 over the next 9 months. To increase return, they sell an 80 call against the stock.
The premium provides immediate income. The cost is that the investor gives up additional upside above the strike price. If the stock rises well above $80, the investor faces opportunity cost (risk).
Continuing the example, if the stock rises to $125:
That missed upside is the main risk the short call adds. Importantly, the investor can still profit if the call is exercised.
A covered call can also reduce downside risk slightly because the investor keeps the premium. For example, if the stock falls to $0, the short 80 call expires worthless and the investor keeps the premium, which offsets part of the stock loss.
Using the same numbers:
Because the option premium can cushion losses (and the main added risk is opportunity risk), covered calls can be recommended to many investors as long as the underlying stock position is suitable. The stock still carries its own risks (systematic and non-systematic).
Let’s summarize the suitability of a covered call:
A covered put, by contrast, is generally very risky. The main reason is the short stock position, which has unlimited risk.
For example, assume an investor is short 100 shares at $30 and sells a 25 put:
However, if the market price rises, the investor can lose unlimited amounts of money on the short stock. The put expires if the market price stays above $25, and the only “protection” is the premium received.
Also watch the name: covered put can sound safer than it is. The put’s risk (which shows up when the market falls) is offset by gains on the short stock. The short stock is still the primary risk driver.
Let’s summarize the suitability of a covered put:
As discussed in the previous chapter, futures and forwards are tied to commodity prices.
Futures contracts are standardized and exchange-traded, which allows investors interested in commodities to trade them. Like options, futures can be used to hedge against price changes. For example, Southwest Airlines went long oil futures in the late 1990s and early 2000s to hedge against rising oil prices. Futures can also be used to speculate on commodity prices rising or falling.
Forward contracts are customized and non-traded, which generally makes them suitable only for parties that actually plan to buy or sell the commodity. In most cases, forwards are used for hedging. Here’s the example from the previous chapter:
A corn farmer projects their harvest to be 2.5 metric tons and they intend to deliver the corn to a cereal distributor. Both the farmer and the distributor are concerned about price fluctuations. If there’s an oversupply of corn due to favorable weather conditions, it’s possible the price of corn will fall, which would negatively impact the farmer. If there’s a shortage of corn, it’s possible the price of corn will rise, which would negatively impact the distributor.
To hedge themselves against the risk of price fluctuations prior to harvest, the two parties could enter into a forward contract. It would be non-standardized to fit the situation, allowing a custom amount of corn to be delivered at a custom date in the future. By locking in the details of the transaction now, both sides obtain protection against adverse price movements.
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