Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksMedium
A portfolio manager is evaluating a derivative contract that gives the holder the right, but not the obligation, to buy 100 shares of XYZ stock at a predetermined price for a specific period. The manager believes XYZ's stock price will increase significantly. Which derivative contract is the manager considering?
- APut option
- BFutures contract
- CForward contract
- DCall option
Show answer & explanationAnswer & explanation
Correct answer: D. Call option
A call option gives the holder the right to buy an underlying asset at a specified price (strike price) within a specific period. This aligns with the manager's expectation of a significant increase in XYZ's stock price, as the call option would become more valuable if the stock price rises above the strike price.
Why the other options are wrong
- A. A put option gives the holder the right to sell, which is beneficial if the stock price is expected to decrease.
- B. A futures contract is a standardized agreement for future delivery, creating an obligation for both parties, similar to a forward but exchange-traded.
- C. A forward contract is a customized agreement to buy or sell an asset at a future date at a predetermined price, but it creates an obligation for both parties, not a right.
Call Option
A derivative contract that gives the buyer the right, but not the obligation, to purchase a specified amount of an underlying asset at a fixed price (strike price) on or before a specified expiration date.
- Used to profit from an increase in the underlying asset's price.
- Buyer pays a premium to the seller (writer).
- Exercised if the market price is above the strike price.
Memory trick: Calls are for Climbing, Puts are for Plunging.