Starting From Zero — What Is a Derivative?
A derivative is a financial contract whose value is derived from the price of something else — called the underlying asset. You don't own the underlying asset itself. You own a contract that gives you certain rights or obligations based on what happens to the price of that asset.
The underlying can be: a stock (e.g., Shopify), a commodity (oil, gold, wheat), a currency (USD/CAD), an interest rate (Bank of Canada overnight rate), or a market index (S&P/TSX 60). This flexibility is what makes derivatives so useful — and so complex.
You want to buy a house in Toronto for $800,000 — but you need 3 months to arrange financing. The seller agrees to lock in the $800,000 price today with a $10,000 deposit. You now have a contract that gives you the right to buy the house at $800,000 in 3 months, regardless of what the market does.
If prices rise to $950,000: your $10,000 deposit generated $150,000 in value — 15× leverage on your money.
If prices fall to $650,000: your deposit is gone and the contract is worthless. Max loss = $10,000.
This is exactly how a call option works. House = underlying asset. The contract = the derivative. The $10,000 deposit = the premium. Your right to buy at $800,000 = the strike price. 3 months = the expiry date.
The distinction that separates options from all other derivatives: an option buyer has a RIGHT, not an obligation. If prices move against them, they can simply walk away — losing only the premium. A futures or forward party has an OBLIGATION — they must complete the transaction regardless of price. The option buyer pays the premium to have this choice. This asymmetry drives everything in derivatives.
Options — Puts, Calls, and Writing
An option contract gives the buyer the right — but not the obligation — to buy or sell a specific quantity of an underlying asset at a predetermined strike price (exercise price) on or before a specific expiry date. The buyer pays a premium upfront for this right.
There are exactly four basic option positions. Every strategy in derivatives — no matter how complex — is just a combination of these four. You must understand the thinking behind each one, not just the payoff. Especially for the exam — the questions test whether you know why someone would use each one.
Position 1 — Buying a Call (Long Call)
A call option gives the buyer the right to buy the underlying asset at the strike price. You buy a call when you expect the price to rise. You want unlimited upside but limited downside.
Priya chooses Option 2. She now has the right to buy 100 SHOP shares at $100 regardless of where the market price goes over the next 3 months.
What Priya paid: $500 (the premium)
Leverage ratio: $10,000 ÷ $500 = 20:1
Profit per share: $135 − $100 = $35
Less premium: $35 − $5 = $30 net profit/share
Total profit = $30 × 100 = $3,000 on $500 invested = 600% return
Compare: If she had bought the shares at $100, she'd have made ($135−$100)×100 = $3,500 — but she would have tied up $10,000 to make that. The option freed up $9,500 of capital while still making $3,000.
Maximum loss = $500 (the premium paid). Nothing more, ever.
Compare: If she had bought shares at $100, she'd have lost ($100−$82)×100 = $1,800. The option limited her loss to $500 — 72% less loss than owning the stock. This defined downside is the defining advantage of buying options.
Position 2 — Buying a Put (Long Put)
A put option gives the buyer the right to sell the underlying asset at the strike price. You buy a put when you expect the price to fall. Puts have two main uses: (1) speculation on a price decline, and (2) portfolio insurance on existing holdings.
Carlos now has the right to sell all 500 SU shares at $58, regardless of where the market goes.
His effective floor: $58/share = $29,000 minimum value
Cost of insurance: $1,500 (5% of position value)
With puts: Carlos exercises — sells 500 shares at $58 despite $38 market price.
Proceeds: $58 × 500 = $29,000.
Less premium: $29,000 − $1,500 = $27,500 net floor.
Insurance saved: $27,500 − $19,000 = $8,500 in protection
Stock gain: ($72−$60) × 500 = $6,000 profit.
Less premium paid: $1,500.
Net gain: $4,500. Insurance cost $1,500 but wasn't needed.
Like buying car insurance you don't use — the peace of mind during uncertainty was worth the cost.
Positions 3 & 4 — Writing (Selling) Options
The option writer (seller) takes the opposite side. They collect the premium upfront but accept an obligation. If the buyer exercises, the writer must fulfill their duty — regardless of how bad the market conditions are. This is where options become genuinely dangerous if done wrong.
Writers make money when options expire worthless. Their income is the premium. Their goal is for the underlying to NOT move in a way that triggers exercise. Time decay works in the writer's favour — every day the option loses time value.
Writing a Covered Call — The Most Common Strategy
Why "covered"? He already owns the 100 shares. If the call is exercised, he can deliver his existing shares — he doesn't need to buy them in the market. This is the key difference from writing a naked call.
RBC at $128: Call expires worthless. David keeps shares + $200 premium. Total return = $200 extra income on his position.
RBC at $135: Call exercised. David sells at $135. Effective sale price = $135 + $2 premium = $137. Still a solid gain from $130.
RBC at $152: Call exercised at $135. David misses the rally above $135. His effective gain is capped at $137 ($135 + $2). He "left money on the table" — but he knew this risk when he wrote the call.
Writing a Naked Call — Maximum Risk, Maximum Danger
Naked call writing = writing a call WITHOUT owning the underlying shares. If the stock rockets past the strike, the writer must buy shares at market (which could be $200, $300, any price) and sell them at the $135 strike. Loss = (market price − strike − premium). Theoretically unlimited. This is the most dangerous derivative strategy for a retail investor. Requires significant margin. Regulators and dealers require high approval levels before permitting naked call writing.
Writing a Cash-Secured Put — The "Buy at a Better Price" Strategy
Outcome B — Telus falls to $21 at expiry: Put is exercised. Sunita is obligated to buy 100 shares at $22 (using her $2,200 cash). Effective cost = $22 − $0.80 = $21.20/share. She bought Telus $2.80 below where it was when she set up the trade. She wanted to own it — this worked.
Outcome C — Telus crashes to $10: Sunita still must buy at $22. She now owns shares worth only $10. Loss = ($22 − $10 − $0.80) = $11.20/share. The $0.80 premium is barely a consolation. This is why cash-secured puts require genuine willingness to own the stock.
The Four Positions — Complete Summary
A scenario will describe a client's view and situation, then ask which option position is appropriate. Always ask: (1) What direction does the client expect? (2) Do they want to generate income or buy protection? (3) Do they own the underlying? Match the view to the position — not just the mechanics.
American-Style vs European-Style Options
Used for: Most exchange-listed individual stock options in Canada and the US — TSX equity options, S&P 500 stock options.
Why it matters: Early exercise is useful when a dividend is coming (call holders may exercise early to capture the dividend), or when an in-the-money put has significant intrinsic value close to expiry.
Premium: Slightly higher than European-style due to the early exercise flexibility.
Used for: Most index options — S&P/TSX 60 index options, S&P 500 index options. Usually cash-settled (you receive the cash difference, not actual delivery of 60 stocks).
Why it matters: Simpler to price (Black-Scholes model is designed for European options). No assignment risk before expiry for the writer.
Cash settlement: At expiry, if the index is above (for calls) or below (for puts) the strike, you receive the difference in cash — no physical delivery of the basket.
Futures, Forwards, Swaps & CFDs
Unlike options where the buyer has a right, the following instruments create obligations for both parties — they must complete the transaction under the agreed terms. Understanding the differences between them is critical for the exam.
Futures Contracts
A futures contract is a legally binding agreement to buy or sell a specific quantity of an underlying asset at a predetermined price on a specific future date. Both buyer and seller are obligated — there is no right to walk away. Both sides can profit and both sides can lose.
On the other side: an Alberta oil producer needs to sell 10 million litres in 6 months and is worried prices could fall. They're happy to lock in $1.05 guaranteed revenue by taking the other side of WestJet's futures contracts.
Both parties eliminated their uncertainty. Now look at what actually happens:
If oil falls to $0.75/litre: WestJet pays $1.05 instead of $0.75. Overpay = $0.30 × 10M = $3.0M. They wish they hadn't hedged. But at $1.05 they knew exactly what their fuel cost would be — that planning certainty was worth the trade-off.
Key insight: Neither party is "wrong" to use the futures. Both eliminated a major uncertainty. Futures exist to let commercial users transfer price risk to those willing to bear it.
Day 2: Oil closes at $77. Loss = $2 × 3,000 = -$6,000 debited tonight. Margin balance = $9,000.
Day 2 night: Maintenance margin threshold = $4,500/contract × 3 = $13,500. Balance $9,000 < $13,500. MARGIN CALL ISSUED.
Day 3 morning: Marcus must deposit $18,000 − $9,000 = $9,000 to restore to initial margin, OR close his positions. If he does neither, the dealer liquidates his contracts.
A 3.75% move in oil (from $80 to $77) wiped out half his margin in 2 days.
Forward Contracts
A forward contract is essentially a futures contract that is NOT exchange-traded. It's a private, customized OTC agreement between two parties — typically a bank/dealer and a corporation. There is no exchange, no standardization, and no daily mark-to-market settlement.
No daily cash calls: No mark-to-market settlement. Gains and losses accumulate until contract maturity. No margin calls disrupting cash management.
No basis risk: Because the forward is tailor-made, there's no mismatch between what you're hedging and what you've hedged with. Futures are standardized — there's almost always some imperfect match.
No easy exit: To close a forward early, you negotiate with the counterparty — you can't simply sell it on an exchange. Less liquid than futures.
Less transparent pricing: OTC pricing is negotiated — you can't see what other participants are paying. Banks earn a spread on every forward.
Solution: They call their bank and enter a 90-day FX forward to sell USD 5M at 1.355 CAD/USD (the bank charges a small spread from the spot 1.36).
If CAD strengthens to 1.22: Spot sale = $6.1M, but forward pays $6.775M. Forward saved $675,000.
If CAD weakens to 1.45: Spot sale = $7.25M, but forward still pays $6.775M. Forward cost $475,000 in opportunity. But the company budgeted and planned around $6.775M — the certainty was worth more than the gamble.
Swaps
A swap is an agreement between two parties to exchange a series of cash flows over a defined period. The most common type is the interest rate swap. Swaps are OTC instruments — documented under an ISDA Master Agreement — used primarily by large corporations, banks, and institutional investors.
A pension fund holds C$500M in 5-year fixed-rate Government bonds (paying 4.8%) but wants floating-rate exposure because their liabilities are inflation-linked and rise with rates.
The swap deal: Air Canada agrees to pay the pension fund a fixed rate of 5.0% per year on a $500M notional. The pension fund agrees to pay Air Canada the floating rate (prime + 1.5%) on the same $500M notional. The notional $500M is never exchanged — only the interest difference changes hands each quarter.
Pays to bank (original debt): Prime + 1.5% (floating)
Receives from pension fund on swap: Prime + 1.5% (floating) — cancels out their floating debt cost
Pays to pension fund on swap: 5.0% fixed
Net result: Air Canada now effectively pays 5.0% fixed — certainty for budgeting and planning.
Pension fund's situation: Receives 5.0% fixed (from swap), pays floating to Air Canada. Net exposure = receives floating — better matches their inflation-linked liabilities.
Contracts for Difference (CFDs)
A CFD is an agreement to exchange the difference in value of an underlying asset between when the contract is opened and when it is closed. You never own the underlying — you simply profit or lose from the price movement.
Three Uses of Derivatives
| Use | Who Uses It | Goal | Real Example |
|---|---|---|---|
| Hedging | Corporations, portfolio managers, farmers, exporters | Reduce or eliminate an existing risk. Not trying to profit — trying to avoid loss. Pays a cost (premium or opportunity cost) for certainty. | Carlos buying protective puts on his SU shares before a geopolitical event. WestJet locking in fuel prices with oil futures. |
| Speculation | Retail and institutional investors, hedge funds, proprietary traders | Take a leveraged directional bet with the goal of profiting from price movements. No underlying position to protect — pure directional view with amplified risk/reward. | Priya buying SHOP calls before earnings expecting a surge. Buying put options on the S&P/TSX expecting a market correction. |
| Arbitrage | Sophisticated institutions, algorithmic traders, market makers | Exploit price discrepancies between related instruments simultaneously for theoretical risk-free profit. Enforces pricing relationships (put-call parity, futures fair value). | If a futures contract trades above its theoretical fair value (spot price + carrying cost), buy the underlying and sell the futures simultaneously, locking in the spread. |
Speculators provide the liquidity that makes hedging possible — without speculators on the other side of every trade, hedgers would have no counterparty. Arbitrageurs enforce fair pricing — without them, options and futures prices would deviate wildly from theoretical values. All three participants serve a role in a functioning derivatives market.
Premium, Greeks, Margin & Leverage
In-the-Money, At-the-Money, Out-of-the-Money
Call ITM: Stock > Strike
Put ITM: Stock < Strike
Example: $100 call when stock = $115 → ITM by $15
ITM options cost more (more intrinsic value). Moving deeper ITM = delta approaches 1.0
No intrinsic value, but maximum time value.
Example: $100 call when stock = $100 → ATM
ATM options have the highest time value and the most sensitivity to volatility changes. Delta ≈ 0.50
Call OTM: Stock < Strike
Put OTM: Stock > Strike
Example: $100 call when stock = $82 → OTM by $18
OTM options are cheaper (less likely to reach strike). Can go to zero rapidly near expiry. Delta < 0.50
The Option Greeks — Measuring Sensitivity
The "Greeks" measure how an option's price changes in response to different market conditions. You need to understand what each one means and the direction of the effect — not the formulas.
The exam won't ask you to calculate Greeks — it asks you to reason with them. Delta: "If the stock rises $1, how much does the call change?" Theta: "Why did the option lose value even though the stock didn't move?" (Answer: time decay). Vega: "Why did both calls and puts get more expensive after the earnings announcement?" (Answer: implied volatility spiked). Focus on the direction and intuition behind each Greek.
Four Main Factors That Affect Option Premium
Margin, Mark-to-Market & Leverage in Derivatives
A trader deposits $10,000 and uses 20:1 leverage to control $200,000 of futures. A 5% adverse move = $10,000 loss — the trader is completely wiped out from a move that barely registers as a rounding error in the broader market. This is why derivatives require the full set of administrative documents (derivatives agreement, risk disclosure, margin agreement, letter of undertaking) before any client can trade. They are not like buying stocks — the risk profile is categorically different.
8.5 — Listed vs OTC markets (detailed comparison table)
8.6 — All trading strategies: bullish (long call, bull call spread, short put), bearish (long put, bear put spread, short futures), income/neutral (covered call, cash-secured put, short strangle), volatility (long straddle, long strangle, calendar spread) — each explained with the market view, construction, payoff, and when to use it
8.7 — All 8 administrative documents explained in full
8.8 — All 3 prohibited derivative practices
Master Summary — 16 exam-critical points
45 Scenario-Based Practice Questions — all options similar length, exam difficulty