CIRE Element 8: derivatives

Element 8 accounts for about 6 of the CIRE's 110 questions, under the syllabus's indicative weighting. Its title is Derivatives. It covers the main derivative contracts, their uses and the rules for clients' derivatives accounts.

What the exam tests

According to the exam syllabus, you need to know:

• the main features of options (calls and puts, American-style and European-style) and of futures, forwards, swaps and contracts for difference (CFDs);
• the basic uses of derivatives: hedging, speculative trading and arbitrage trading;
• the basic transactional elements of futures and options, such as the premium, margin, mark-to-market and leverage;
• the differences between listed and over-the-counter (OTC) derivative markets;
• the single and multi-legged strategies, from bullish and bearish to spread and volatility strategies;
• the administrative requirements of derivative trading with clients, and the prohibited derivative trading practices.

Source: CIRE syllabus (CIRO, January 2025), learning outcomes 8.1 to 8.8.

The key ideas, in plain English

1. Options: a right for the holder, an obligation for the writer

Like every derivative, an option takes its value from an underlying interest, such as a share or an index. It gives its buyer, the holder, a right but not an obligation: a call is the right to buy the underlying interest at the strike price for a set period (when it can be exercised depends on its style); a put is the right to sell it at that price. The holder pays a premium. The seller, the writer, receives the premium and takes on the obligation: if a physically settled equity option is exercised, the writer is assigned and must sell (for a call) or buy (for a put) the shares at the strike price.

On the option itself, the holder can lose no more than the premium paid. For the writer, losses can exceed the premium received; uncovered writing requires margin. An American-style option can be exercised at any time up to and including expiration, a European-style option only at expiration. Generally, other things being equal, more time to expiry and higher volatility raise the premiums of both calls and puts.

2. Futures, forwards, swaps and CFDs

• Futures oblige both parties to settle at a price set today, on a future date, by delivery or in cash. They are standardized, exchange-traded and cleared through a clearing house.
• A forward creates the same kind of obligations, but it is typically a private OTC agreement with customized terms, usually settled at maturity.
• A swap exchanges a series of cash flows calculated on a notional amount, such as fixed-rate for floating-rate interest.
• A contract for difference (CFD) is an OTC agreement with a dealer on the change in an underlying's price; the client never owns the underlying interest.

Futures margin is a good-faith deposit from both sides, not a down payment, and positions are marked to market every day. That creates leverage: with $5,000 of margin on a long futures position worth $100,000, a 1.5% fall in the futures price produces a $1,500 loss—30% of the initial deposit. On futures, a client can lose more than the amount deposited.

3. Hedging, speculation and arbitrage

What matters is the trader's existing or anticipated exposure.

• Hedging reduces the risk of a position held or planned. A short hedge (selling futures or buying puts) protects against a fall; a long hedge (buying futures or calls), against a rise. A hedge usually costs a premium, or gains given up.
• Speculative trading takes on price risk to profit from an expected price change; speculators are drawn to derivatives by leverage, and they bring liquidity.
• Arbitrage trading buys where a price is low and sells where it is high, at the same time, to profit from a price gap without a view on direction.

4. Listed or over the counter?

	Listed (exchange-traded)	Over the counter (OTC)
Terms	Standardized by the exchange	Negotiated between two parties; can be customized
Counterparty risk	Low: a clearing house (the CDCC in Canada) guarantees performance	Higher for bilateral contracts: each party depends on the other
Exiting a position	Usually an offsetting trade in the market	Generally only with the same counterparty, which can be hard before maturity

5. Basic strategies, in words

Results are at expiry, ignoring commissions, fees and dividends.

• Bullish: buying a call. A $50 call bought for $2 breaks even at $52 a share (strike price plus premium); the most the buyer can lose is the $2.
• Bearish: buying a put. The mirror image, with the loss limited to the premium.
• Income-producing: covered call writing. A shareholder writes a call, keeps the premium and accepts a sale price capped at the strike price.
• Spread: the bull call spread. Buy a call and sell a higher-strike call, with the same underlying, expiry and number of contracts: a lower cost, for a capped profit.
• Neutral or volatility: the straddle, a call and a put with the same strike price and expiry. The writer gains if the price stays near the strike price; the buyer needs a move larger than the combined premiums, either way.

6. Derivatives accounts and prohibited practices

Before a client's first derivatives transaction, the dealer must:

• obtain a completed derivatives account application and a signed derivatives trading agreement (for an institutional client only, a letter of undertaking can replace it);
• give the client the most recent derivatives risk disclosure statement (for a retail client, before accepting the first derivatives order, with an acknowledgement of receipt);
• record the written approval of the designated Supervisor, who checks whether the risks of the client's intended strategies suit the client.

A signed margin agreement comes before a margin account opens; discretionary and managed accounts need their own agreements.

The dealer's review must detect, among other things, trading while under margin, trading beyond margin or credit limits and cumulative losses exceeding risk limits: losses past the client's approved cumulative loss limit. The limit applies to accounts trading highly leveraged products, such as futures, except hedging accounts.

Three important distinctions to understand

• Holder and writer. The holder has a right and pays the premium; the writer has an obligation and receives it.
• Futures and forwards. Both oblige both parties; futures are standardized and exchange-traded, a typical forward is customized and private.
• Hedger, speculator and arbitrageur. The first reduces the risk of an existing or anticipated exposure, the second takes on risk to profit from a forecast, the third profits from a price gap.

Test yourself: 3 questions

Original CIROPrep questions, in the style of the exam.

1. A client wrote one put contract on DEF shares (100 shares) with a $40 strike price. At expiry, DEF trades at $35; the option is exercised and the client is assigned. What must the client do?

• a) Sell 100 DEF shares at $40 each
• b) Buy 100 DEF shares at $35 each
• c) Buy 100 DEF shares at $40 each
• d) Nothing: the writer keeps the premium and has no further role

Answer

c) An assigned put writer must buy the shares at the strike price. Option a) is a call writer's obligation; b) uses the market price instead of the strike price; d) is wrong: once assigned, the writer must perform; the premium was the payment for taking on that obligation.

2. An investor buys a $40 call for $1.50 and a $40 put for $1.00 on the same stock, with the same expiry. Ignoring commissions, fees and dividends, where must the stock be at expiry for a profit?

• a) Below $37.50 or above $42.50
• b) Below $38.50 or above $41.50
• c) Between $37.50 and $42.50
• d) Above $42.50 only

Answer

a) The straddle costs both premiums, $2.50, so the stock must move more than $2.50 from $40, either way. Option b) counts only the call's premium; c) is where the straddle's writer would profit; d) ignores the put.

3. A client's futures account (not a hedging account) has a lifetime cumulative loss limit of $30,000 and has lost $26,000. It has the margin it requires and is within its credit limit. A new position then loses $5,000. Which practice must the dealer's review detect?

• a) Trading while the account is under margin
• b) Trading beyond margin or credit limits
• c) None, because a lifetime limit is checked only once a year
• d) Cumulative losses exceeding risk limits

Answer

d) Cumulative losses are now $31,000, past the $30,000 limit. Options a) and b) don't fit: margin and credit are within limits. Option c) is wrong: the yearly validation confirms the limit with the client; the dealer's review must still detect losses that pass it.

Continue your preparation

Want to practise Element 8 in more depth? The Module — Element 8 has lessons, practice questions with an explanation for every answer, summaries, flashcards, a mind map and exam tips, in English and French. $29 plus applicable sales taxes · one payment · 6 months of access. Explore the Element 8 module.

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Read next: Element 6, market integrity, trade execution and settlement and Element 3, scope of client relationships.