Options and Warrants

Lesson

Options and warrants are derivative securities. Derivative securities derive their value from an underlying asset, such as stocks, bonds, or commodities. Options and warrants give the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price before a specified expiration date.

Practice Question #1

Which of the following best describes an option?

A) An obligation to buy or sell an underlying asset at a specified price on a specified future date

B) A financial agreement to exchange cash flows or other financial variables

C) A contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before a specified expiration date

D) A security that gives the holder the right to receive dividends from a company

Select an option above to see an explanation here.

A) This describes a futures contract, not an option. B) This describes a swap, not an option. C) This is the correct definition of an option. D) This describes a stock, not an option.

Terms

Derivative:: A financial instrument whose value is based on the value of an underlying asset.
Option:: A contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before a specified expiration date.
Warrant:: A security that gives the holder the right, but not the obligation, to buy a specific number of shares of the underlying stock at a specified price before a specified expiration date.
Call option:: An option that gives the holder the right to buy the underlying asset at a specified price before a specified expiration date.
Put option:: An option that gives the holder the right to sell the underlying asset at a specified price before a specified expiration date.
Strike price:: The specified price at which an option holder can buy or sell the underlying asset.
Expiration date:: The date an option or warrant becomes invalid and can no longer be exercised.
In-the-money:: An option whose strike price is favorable compared to the current market price of the underlying asset.
Out-of-the-money:: An option whose strike price is unfavorably compared to the underlying asset's current market price.
Exercise:: The act of using the rights granted by an option or warrant to buy or sell the underlying asset.

Practice Question #2

What is the main difference between a call option and a put option?

A) A call option gives the holder the right to buy the underlying asset, while a put option gives the holder the right to sell the underlying asset.

B) A call option gives the holder the right to sell the underlying asset, while a put option gives the holder the right to buy the underlying asset.

C) A call option has a specified expiration date, while a put option does not.

D) A call option is a type of warrant, while a put option is a type of futures contract.

Select an option above to see an explanation here.

A) This is the correct difference between a call and a put option. B) This is the opposite of the correct difference. C) Both call and put options have specified expiration dates. D) Both call and put options are options, not warrants or futures contracts.

Historical Example

In the late 1990s, a major technology company issued stock warrants to its employees as part of their compensation packages. The warrants allowed employees to buy company stock at a specified price, significantly lower than the market price. As the stock price rose, many employees exercised their warrants and made substantial profits.