FINRA Series 3 Free Practice Questions 24

Spread and spread margin
A spread position is created as a result of the concurrent purchase and sale (long and short positions) of related but not identical contracts. The spread margin is the amount required to establish and maintain spread trading. Since the price volatility of the two positions combined can be expected to remain lower than that of each position separately, the spread margin requirements are lower as well. Calculating a spread margin requires that the following variables be considered: outright margin, spread credit, and contract ratio.

Outright margin, spread credit, and contract ratio
These terms are applicable to the calculation of margin requirements for spread contracts, and are defined as follows:
• Outright margin is simply the maintenance margin, and is calculated as if each of the legs of the spread were traded separately. If the contract is being traded speculatively, the margin is calculated as the hedge maintenance margin increased by a specific factor.
• Spread credit is determined by the exchange, and represents the rate of reduced price volatility for the two positions trading together.
• Contract ratio represents the ratio of the number of contracts to each leg of the spread.

Intrinsic value
Intrinsic value is the difference between the strike price of an option and the price of the underlying security. If the option is a call, intrinsic value exists if the price of the security is greater than the strike price. If the option is a put, intrinsic value exists if the price of the security is lower than the strike price. A negative intrinsic value is expressed as zero.

Time value, and option premium
If the price of an option is greater than the calculated intrinsic value, the option can be said to have time value. That is, the length of time until the option expires represents an opportunity for the price of the underlying security to move in a favorable direction. This opportunity is reflected in the price of the option. An option premium is the amount received by the writer or seller of the option from the buyer, and represents the sum of the intrinsic value and the time value.

Option delta
As the term is used in option pricing, option delta refers to the relationship between changes in the price of an option and the price of the underlying asset. This relationship can be used to try to quantify how the price of an option will change when there is a change in the value of the underlying asset. For example, a delta of 0.50 or 50% indicates that a $10 change in the value of an asset will cause a corresponding $5 change in the value of the option. A delta of zero would indicate that there is no relationship between the price of an option and the price of an asset. Conversely, a delta of 1.0 or 100% would represent a 1:1 relationship; a $1 change in the price per asset = a $1 change in the price per option. An option delta can be useful when constructing hedge positions, because it can be used to predict the expected change in option price (and thus the number of contracts required) relative to the underlying asset to be hedged. Speculators find value in the delta in the same fashion, as they trade in options based on expectations of changes in the underlying asset.

European style option and American style option
An option contract is said to be European style if the contract must be held until the maturity date in order be exercised. In contrast, an American style option can be exercised at any point during the period prior to the expiration date. Because of this feature, American style options tend to be priced at a premium compared to European style options. This premium reflects the additional exercise flexibility.

Discount rate and value of a single bill
U.S. Treasury bills are quoted as 100 minus the discount rate of the delivery month. At a price of 99.27, the discount rate is calculated as 100 – 99.27, or 0.73%. The contract standard is a single 13 week T-Bill with a face value of $1,000,000. Therefore, the contract value is $992,700. Note that T- Bill futures contracts are cash settled transactions, unlike bonds and notes that are settled with delivery.

Locked limit
Daily price limits are expressed in terms of a fixed amount above or below the current closing price of a contract. A price is said to have reached its locked limit when it has risen or fallen to its upper or lower limit amount. At this point, all trading in the contracts is suspended until the following day. However, limits can be adjusted based on the rules of the exchange. Since price limits exist to control panic buying and selling, the factors underlying a locked limit are examined to ascertain any such behavior. For example, if volatility is a result of the natural behavior of traders as an expiration period approaches (buying and selling to unwind positions), the limits may be adjusted so that trading can resume.

Circuit breakers
Circuit breakers are a coordinated, market-wide suspension of trading that first emerged when there were large price changes in the Dow Jones Industrial Average (DJIA). Such trading interruptions are designed to provide a “cooling off” period, during which market participants can reassess their trading strategies. This allows for the reestablishment of a more balanced trading environment within the market. Exchanges such as the Chicago Mercantile Exchange (CME) have adopted the same circuit breakers in futures and options contracts using stock indices as the underlying measure. For example, the CME recently established DJIA circuit breakers at 1300, 2650, and 3950 points, which represent index changes of 10%, 20%, and 30%. Similar breaks were established for all index-based contracts.

Methods to settle a futures contract
Futures contracts can be settled on the contract settlement date through either physical delivery (primarily for hard assets such as agricultural products and metals, but also for treasury notes and bonds) or through a cash payment (for nondeliverables such as interest, currency rates, and stock indices, and also for treasury bills). Liquidation as a form of settlement consists of offsetting trades, also called reversing trades. Examples of offsetting trades include selling to offset a long position or buying to offset a short position. The intent is to revert to a zero position, though getting to a position of exactly zero is not always possible. Offsets are by far the most prevalent method of settling a futures contract.