FINRA Series 3 Free Practice Questions 78

Vertical call spreads
With a vertical call spread, you have two options of the same month but with different strike prices that are spread against each other. The vertical call spread is bullish, and the vertical put spread is bearish. For example, you’re bullish wheat, it’s March, and May wheat is trading at $4.20. You buy the May 420 call, pay 22¢, simultaneously sell the May 450 call, and take in 7¢. Your cost (excluding commissions) is the difference between the two premiums—in this case, 15¢, or $750. The difference (always a debit) is your maximum risk. If the market at expiration closes below 420, you lose the 22¢ and keep the 7¢, a maximum risk of 15. Your maximum profit is the difference between the strike prices minus the debit. In this case, 450 – 420 = 30 and 30 – 15 = 15. At expiration, above 450, you lose a penny for a penny on the 450 what you make on the 420. So, your maximum profit is at or above 450. Returning 30 for your 22 investment is the lower-priced call, but you keep the 7¢, for a total of 15¢. Why spread vertically? In one respect, bull spreading calls offer the best of both worlds. The risk, as in buying options, is strictly limited. You lower your overall cost by benefiting from the time decay of selling premium. You are selling premium on the greater out-of-the-money option, which is more likely to expire worthless than the lower-priced option. The main disadvantage is that the profit is limited, and this eliminates one of the main advantages of buying options. There is still a premium cost, one of the main disadvantages of buying options, and you incur double commissions.

Ratio spreads
A 2:1 ratio call spread involves buying one lower-priced call and selling two higher-priced calls.

1. Avoid deep in-the-money options
The two key advantages of buying options are leverage and limited risk. If an option is deep in the money, it cuts down on your leverage and adds to your risk. Even though the risk is still limited, you’re paying more and therefore have more to lose. You cut down on your leverage because you need a bigger move in the underlying asset to generate a significant profit. The whole idea of leverage is to take a small amount of money and own an option to exercise into an asset worth many times as much. When buying deep in-the-money options, you tie up a lot more money that can be used for other opportunities. I don’t like selling deep inthe-money options either. You tie up a considerable amount of capital this way (since you need to margin the position). The biggest advantage to an option seller is time decay, and deep in-the-money options have less time value; therefore, you have less to gain the easy way and more risk with the intrinsic value component. Bottom line: I stay away from deep in-the-money options when buying or selling. Of course, when buying options, your objective is to
turn an out-of-the-money, at-the-money, or slightly in-the-money option into a deep in-the-money option. Your objective when selling options is to avoid turning your sale into a deep in-the-money. This is an effective way for your wallet to go deep out of money!

Fundamental analysis basically is the study of supply and demand. The fundamentalist says that the cause and effect of price movement is explained by supply and demand. Here’s an example of how fundamental analysis might work: Fundamental statistics are available in market reports. You might read new copper mine production this year will be 300,000 tons, manufacturing demand is projected to be 400,000 tons, and “above-ground” supplies available to the market are 50,000 tons. A fundamentalist would conclude that these statistics project a coming
supply deficit of 50,000 tons. Therefore, logically copper prices must rise to ration or diminish this impossible level of demand. Fundamental analysis appeals to our logic. After all, if Brazil is suffering through a drought during the flowering phase of the soybean plant, one can rationally explain why bean prices are rising. A good fundamentalist is able to forecast a major price move well in advance of the technician. Some fundamentalists have what amounts to “inside information” (which is perfectly legal in the futures markets). If Cargill has a scout in Africa who identifies a cocoa-killing fungus that is devastating that crop, odds are Cargill will act on this information long before you or I hear about it.
Fundamentalists are able to trade the courage of their convictions and are not shaken out as easily during false market movements. They are better able emotionally to maximize positions because fundamentals can take a long time to change. In late 1995, with corn trading in the mid-$2-per-bushel range, I noticed China (formerly the third-largest corn exporter, and the largest exporter in Asia) had turned into a corn importer. This was the first time in history China had imported corn from the United States. China’s livestock production had grown to a rate that could not keep pace with its reduced crop production of that year. In my mind, this was a significant fundamental, which was a major reason corn prices were able to hit new all-time record highs within a six-month period. No doubt, fundamentals can be powerful and allow a trader to stay with a position longer than he otherwise might stay. However, they also can prompt a trader to stay with a position longer than he should stay.

The 4 futures groupings
While there are hundreds of Exchange-listed futures contracts globally, and most of them have liquid options markets, the major futures markets basically can be arranged in four groupings:
• Financial futures
• Energies
• Agriculturals
• Metals

The following are major industrial metal fundamentals:
• Economic activity: Watch the economies of the major industrialized nations that comprise the prime demand fundamentals of this group. Each
of the metals, of course, has its own fundamentals (zinc and lead are generally mined together, for example), but industrialized demand is the key. If there is a threat of an economic slowdown, this will be reflected in lower prices.
• LME stocks: Every day, the LME releases its widely watched stocks report, which is a good measure of supply. It lists the stocks in the
Exchange-approved warehouses for aluminum, copper, zinc, tin, and lead.
• Mining strikes, production problems, and war: Demand traditionally soars for the industrial metals in times of increased defense spending. Copper has been called the “war metal.”
• Inflation: The industrial metals have, at times, been called “the poor man’s gold,” and they heat up in an inflationary environment.

Here are the major metals fundamentals:
• Central banks and inflation: Watch what the central banks are doing. At times, the central banks are aggressive sellers, and at times, they are absent from the market. When they are printing money, gold by default rises (more currency units in circulation require a higher gold price per ounce). Keep an eye on the global political climate and how gold reacts to it. In times of instability, gold is considered a store of value. War or a loss of confidence in traditional investments can cause a shift of funds into gold. Watch China, India, and other growing economies. As income growth increases there, so has gold demand. Most importantly, keep an eye on inflation and inflationary expectations. In the long run, the prices of gold and all other precious metals are sensitive to inflation. Regarding silver, watch the price of gold, but also watch the prices of copper, zinc, and lead. Because much of the new production of silver comes as a by-product of these three metals, if the price of the three is depressed and production curtailed, silver output will suffer as well. The reverse is also true. Watch Indian imports. Silver is a precious metal of choice in India, and a strong economy there increases demand.
• Platinum: Regarding platinum, watch Japan. In Japan, platinum is the precious metal of choice, with more of it used for jewelry than gold. A strong economy in Japan is good for platinum prices. This is an industrial metal and a precious metal, and the demand for platinum is somewhat dependent on the health of the automotive, electrical, dental, medical, chemical, and petroleum.

The following are major fundamentals for the softs:
• Stocks-to-usage ratios: The level of sugar supplies in relation to demand, the stocks-to-consumption ratio, is the major statistic traders talk about when measuring the degree of “tightness” in the marketplace. For sugar, a ratio of 20% to 30% is considered low and is consistent with higher prices. When prices spiked above 25¢ per pound in 1980, this ratio was in the mid-20s. When the ratio rose above 40% in the mid-1980s, prices fell as low as 3¢. Because the free-floating supply of sugar is comparatively low, it does not take a big move in the stocks-to-consumption ratio to result in a major price move. Candy sales are important, as is the price of corn. (High-fructose corn syrup is a competitor of sugar.)
• For cocoa, the “grind” is the term used to measure consumption: Higher grinds indicate rising demand and vice versa. From time to time, the International Cocoa Organization (ICO) forges an agreement intended to support prices. The ICO is a group of producing nations that purchases cocoa for its own account and stores it to push prices upward. When a shortage develops, the ICO releases stocks onto the market. Coffee consumption is believed to be more inelastic, with a major price increase needed to curtail demand. However, the sharp rise in coffee prices in 1996 to 1997 was met by a commensurate reduction in consumption. Americans consume close to double what the Germans drink (they are number two), followed by the Chinese, the French, the Japanese, and then those from the other major EEC countries. Consumption trends need to be followed closely. In the late 1940s, the United States accounted for two-thirds of world imports, but because of the growing popularity of coffee globally, this number is down to one-third.
• Crop yields: Weather, disease, insects, and political and economic conditions in the producing countries all affect production rates. For
example, the great freeze in 1994 caused coffee prices to surge from less than $1 per pound to close to $3. For coffee, the International Coffee Organization provides useful statistics, such as number of bags produced by country.

Spreads
Using spreads (at times called straddles or switches) is a more sophisticated way of trading, and it fits well into the game plan of many traders. I know some traders who trade only spreads because they feel spreads are the best way to limit some of the risks inherent in futures and options. Actually, this is the main purpose of spreading: to reduce risk.
When you enter a spread, the objective is not necessarily to make money on a rise or fall in the market in question but rather to make money from a change in the relationship between different prices. When you put on a spread, you buy one contract while simultaneously selling
another. You are long and short in either two related commodities or two different months of the same commodity at the same time. The relative change between the two determines your profit or loss.
The two major categories of spreads are intramarket and intermarket spreads.

Intramarket spreads
Intramarket spreads consist of buying one month in a particular commodity and simultaneously selling a different month in the same commodity.