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Question 1 of 30
1. Question
Which of the following mistakes did losers tend to do which is/are not advisable for a trader to do?
I. They lose more in their winning positions than they make in their losing positions.
II. They have few fears or reservations before a losing trade but plenty after.
III. They get trapped by other’s doubts, brought about by previous mistakes. They tend to overanalyze (particularly after a string of losers) to the point that they get trapped into inaction. As a result, they miss the best trades while watching from the sidelines.
IV. They take on high-risk trades because they visualize only the profits and not what could go wrong. Then, if something does go wrong, the stress can put them on tilt. Some losers are compulsive, always needing to play, regardless of whether the odds favor their play.
Correct
Here’s what the losers do (train yourself not to do these things):
• They lose more in their losing positions than they make in their winning positions.
• They get aggressive with their losers (by adding to them, or “averaging down”).
• They have few fears or reservations before a losing trade but plenty after.
• They get trapped by their own self-doubts, brought about by previous mistakes. They tend to overanalyze (particularly after a string of losers) to the point that they get trapped into inaction. As a result, they miss the best trades while watching from the sidelines. They price every trade (instead of entering ”at the market”), and because of this, they miss some good ones but are filled with every bad one.
• They have a goal (and that’s fine) but get obsessed about reaching that goal (which is not good). This allows losers to get out of control.
• They take on high-risk trades because they visualize only the profits and not what could go wrong. Then, if something does go wrong, the stress can put them on tilt. Some losers are compulsive, always needing to play, regardless of whether the odds favor their play.
• They’re opinionated, argumentative, and great at placing blame (on the broker, the funds, the government—anything but what they’re in control of).Incorrect
Here’s what the losers do (train yourself not to do these things):
• They lose more in their losing positions than they make in their winning positions.
• They get aggressive with their losers (by adding to them, or “averaging down”).
• They have few fears or reservations before a losing trade but plenty after.
• They get trapped by their own self-doubts, brought about by previous mistakes. They tend to overanalyze (particularly after a string of losers) to the point that they get trapped into inaction. As a result, they miss the best trades while watching from the sidelines. They price every trade (instead of entering ”at the market”), and because of this, they miss some good ones but are filled with every bad one.
• They have a goal (and that’s fine) but get obsessed about reaching that goal (which is not good). This allows losers to get out of control.
• They take on high-risk trades because they visualize only the profits and not what could go wrong. Then, if something does go wrong, the stress can put them on tilt. Some losers are compulsive, always needing to play, regardless of whether the odds favor their play.
• They’re opinionated, argumentative, and great at placing blame (on the broker, the funds, the government—anything but what they’re in control of). -
Question 2 of 30
2. Question
Which of the following things that a trader should do to win?
I. They make more in their losing positions than they win in their losing positions.
II. They trade for the future, guided by what the market is doing (reality) and not their bias of what the market should be doing (hope). And they are totally prepared, ready to take the trades. They have a plan and follow it.
III. They take on a high-risk trade only if there’s an edge in that trade—a favorable risk-to-reward ratio. They have the patience to wait for the best signals, and when signaled, they can act without reservations or anxiety. They have the ability to buy or sell “at the market,” knowing they could miss some of the best trades by pricing.
IV. Because they have a plan and the discipline to follow it, they are relaxed, without stress or excuses. How do I avoid stress during trading hours? I do my market analysis before the market opens and write out a script with the plan of action for varying circumstances.
Correct
Here’s what the winners do (train yourself to do these things):
They make more in their winning positions than they lose in their losing positions. How do they accomplish this? By (a) holding the winners longer and (b) by being bold—getting aggressive with winners by sizing up. They have the ability, on good days, to quickly make back the bad day’s losses.
• They trade in the present, guided by what the market is doing (reality) and not their bias of what the market should be doing (hope). And they are totally prepared, ready to take the trades. They have a plan, and follow it. Once in a trade, if the market is giving them what they expected, they play it out; however, if it isn’t, they accept what the market is prepared to give them. Again, this is reality versus hope.
• They take on a high-risk trade only if there’s an edge in that trade—a favorable risk-to-reward ratio. They have the patience to wait for the best signals, and when signaled, they can act without reservations or anxiety. They have the ability to buy or sell “at the market,” knowing they could miss some of the best trades by pricing. They realize that “bad price fills” can many times be a symptom of the very best trades.
• Because they have a plan and the discipline to follow it, they are relaxed, without stress or excuses. How do I avoid stress during trading hours? I do my market analysis before the market opens and write out a script with the plan of action for varying circumstances. . . While I don’t always trade “at the market” (at times I try to price an entry better using a limit order), if I don’t get the trade on fairly quickly, I will not hesitate to go “at the market” to get it on (even if I have to “pay up”). When the trade is completed, I review what I did right and what I did wrong. Did I get out too soon (profitable trades) or too late (losing trades)? Did I size up correctly to maximize my profit? Did I act in a disciplined, consistent manner, or did I panic or gamble?Incorrect
Here’s what the winners do (train yourself to do these things):
They make more in their winning positions than they lose in their losing positions. How do they accomplish this? By (a) holding the winners longer and (b) by being bold—getting aggressive with winners by sizing up. They have the ability, on good days, to quickly make back the bad day’s losses.
• They trade in the present, guided by what the market is doing (reality) and not their bias of what the market should be doing (hope). And they are totally prepared, ready to take the trades. They have a plan, and follow it. Once in a trade, if the market is giving them what they expected, they play it out; however, if it isn’t, they accept what the market is prepared to give them. Again, this is reality versus hope.
• They take on a high-risk trade only if there’s an edge in that trade—a favorable risk-to-reward ratio. They have the patience to wait for the best signals, and when signaled, they can act without reservations or anxiety. They have the ability to buy or sell “at the market,” knowing they could miss some of the best trades by pricing. They realize that “bad price fills” can many times be a symptom of the very best trades.
• Because they have a plan and the discipline to follow it, they are relaxed, without stress or excuses. How do I avoid stress during trading hours? I do my market analysis before the market opens and write out a script with the plan of action for varying circumstances. . . While I don’t always trade “at the market” (at times I try to price an entry better using a limit order), if I don’t get the trade on fairly quickly, I will not hesitate to go “at the market” to get it on (even if I have to “pay up”). When the trade is completed, I review what I did right and what I did wrong. Did I get out too soon (profitable trades) or too late (losing trades)? Did I size up correctly to maximize my profit? Did I act in a disciplined, consistent manner, or did I panic or gamble? -
Question 3 of 30
3. Question
Which of the following statements is/are true for margin deposits?
I. Margin deposits are set by the director, and they can change with price movements and market volatility.
II. Because you are trading for future delivery and borrowing everything, interest is charged on the balance.
III. Margin is money deposited in your brokerage account that serves to guarantee the performance of your side of the contract.
IV. If you make money on the trade, upon liquidation, your total margin deposit is returned, along with your profits. Commissions are
deducted, and they are a cost.Correct
Margin deposits are set by the Exchange, and they can change with price movements and market volatility. Because you are trading for future delivery and not borrowing anything, no interest is charged on the balance. Margin is not a partial payment or a down payment at all, and it’s not even considered a cost. If you make money on the trade, upon liquidation, your total margin deposit is returned, along with your profits. Commissions are deducted, and they are a cost. Margin is money deposited in your brokerage account that serves to guarantee the performance of your side of the contract. Margin is a form of “earnest money” deposited by both the longs and the shorts, and it serves to ensure the integrity of every futures transaction. In effect, margin ensures that you are paid when you win and that whoever is on the other side of your transaction is paid if you don’t.
Incorrect
Margin deposits are set by the Exchange, and they can change with price movements and market volatility. Because you are trading for future delivery and not borrowing anything, no interest is charged on the balance. Margin is not a partial payment or a down payment at all, and it’s not even considered a cost. If you make money on the trade, upon liquidation, your total margin deposit is returned, along with your profits. Commissions are deducted, and they are a cost. Margin is money deposited in your brokerage account that serves to guarantee the performance of your side of the contract. Margin is a form of “earnest money” deposited by both the longs and the shorts, and it serves to ensure the integrity of every futures transaction. In effect, margin ensures that you are paid when you win and that whoever is on the other side of your transaction is paid if you don’t.
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Question 4 of 30
4. Question
If the initial margin requirement is $3000, then how much should be the maintenance margin?
Correct
Assume that corn is trading at $6 per bushel, and the initial margin requirement is $2,000. A corn contract has a size of 5,000 bushels, so at $6 per bushel, the total value of the contract is $30,000. However, all that is required to purchase or sell a contract is $2,000 (in his example, about 6%). A rule of thumb for maintenance margin is that it will be at the 75% level of initial. If the initial is $2,000, for example, maintenance might be $1,500.
Incorrect
Assume that corn is trading at $6 per bushel, and the initial margin requirement is $2,000. A corn contract has a size of 5,000 bushels, so at $6 per bushel, the total value of the contract is $30,000. However, all that is required to purchase or sell a contract is $2,000 (in his example, about 6%). A rule of thumb for maintenance margin is that it will be at the 75% level of initial. If the initial is $2,000, for example, maintenance might be $1,500.
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Question 5 of 30
5. Question
Why it is recommended to trade in the active month?
I. The active month is the one with the lowest open interest.
II. Active months have the greatest number of players and, therefore, the most liquidity.
III. Because of greater liquidity, you can get in and out with a large degree of slippage.
IV. Slippage means having your order filled at a price unfavorably different from that which existed as the last trade.
Correct
Which month should you trade? This is a general rule of thumb only, but unless you have a specific reason for trading a specific month, trade the active month. For example, say that it’s May but you want to be short December corn because this is the first new crop month and, despite tight supplies, you think there’s a big crop coming and predict that this month will fall faster. Otherwise, you would trade the active month. The active month is the one with the highest open interest, and you can obtain this information from the Exchange for any particular commodity at any point in time. This is because the active months have the greatest number of players and, therefore, the most liquidity. Because of this, you can get in and out with a smaller degree of slippage. Slippage, in effect, means having your order filled at a price unfavorably different from that which existed as the last trade.
Incorrect
Which month should you trade? This is a general rule of thumb only, but unless you have a specific reason for trading a specific month, trade the active month. For example, say that it’s May but you want to be short December corn because this is the first new crop month and, despite tight supplies, you think there’s a big crop coming and predict that this month will fall faster. Otherwise, you would trade the active month. The active month is the one with the highest open interest, and you can obtain this information from the Exchange for any particular commodity at any point in time. This is because the active months have the greatest number of players and, therefore, the most liquidity. Because of this, you can get in and out with a smaller degree of slippage. Slippage, in effect, means having your order filled at a price unfavorably different from that which existed as the last trade.
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Question 6 of 30
6. Question
Which of the following statements is/are true regarding price in the options contract?
I. If the price of the commodity is too high in relation to the futures price, then the people involved in the use of a particular commodity sell the low-priced futures contracts and take delivery. Their buying, in effect, pushes futures prices up to meet the physical price.
II. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity sell the contract to make a delivery because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price.
III. If the price of the commodity is too high in relation to the futures price, then the people involved in the use of a particular commodity buy the low-priced futures contracts and take delivery. Their buying, in effect, pushes futures prices up to meet the physical price.
IV. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity buy the contract to make a delivery because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price.
Correct
This option is as important in theory as in practice because it is what allows physical commodity prices and the Exchange-traded contracts to come together at price. If the price of the commodity is too high in relation to the futures price, then the people involved in the use of a particular commodity buy the low-priced futures contracts and take delivery. Their buying, in effect, pushes futures prices up to meet the physical price. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity sell the contract to make a delivery because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price. This entire process is known as convergence. This potential process of convergence is what makes the system work; however, in practice, only 1% to 2% of all commodity contracts end in delivery. Odds are that you, as a speculator, will never get involved in delivery, and there’s no need to. In fact, even the majority of hedgers do not use the markets to actually make or take delivery; they use the futures as a pricing tool to help stabilize their revenues and their costs.
Incorrect
This option is as important in theory as in practice because it is what allows physical commodity prices and the Exchange-traded contracts to come together at price. If the price of the commodity is too high in relation to the futures price, then the people involved in the use of a particular commodity buy the low-priced futures contracts and take delivery. Their buying, in effect, pushes futures prices up to meet the physical price. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity sell the contract to make a delivery because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price. This entire process is known as convergence. This potential process of convergence is what makes the system work; however, in practice, only 1% to 2% of all commodity contracts end in delivery. Odds are that you, as a speculator, will never get involved in delivery, and there’s no need to. In fact, even the majority of hedgers do not use the markets to actually make or take delivery; they use the futures as a pricing tool to help stabilize their revenues and their costs.
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Question 7 of 30
7. Question
Which of the following statements is/are true regarding the basis in short and long hedge?
I. If a short hedger (one who sells futures) experiences a widening of the basis (where cash prices have fallen to a greater degree than futures—either cash has fallen faster or risen slower than futures), a basis loss may result. In other words, the short hedger’s cash position loss may be greater than the gain realized on the futures side of the transaction.
II. In a rising market, the gain on the cash side of the transaction would be as large as the loss on the futures side.
III. A basis gain would occur with a widening basis on a short hedge. The futures would rise in price to a greater degree than the cash.
IV. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for a long hedger (the cash falls less, or rises more, in relation to the futures).
Correct
The basis
In these examples, I have kept the basis fairly constant, but in reality, it can change. If a short hedger (one who sells futures) experiences a widening of the basis (where cash prices have fallen to a greater degree than futures—either cash has fallen faster or risen slower than futures), a basis loss may result. In other words, the short hedger’s cash position loss may be greater than the gain realized
on the futures side of the transaction. Or, in a rising market, the gain on the cash side of the transaction would not be as large as the loss on the futures side. Conversely, a basis gain would occur with a widening basis on a long hedge. The futures would rise in price to a greater degree than the cash. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for a long hedger (the cash falls less, or rises more, in relation to the futures). Basis gains or losses are a risk to a hedger, but they’re not nearly as big a risk as what is called flat price risk. The price of heating oil may move 20¢ per gallon in a couple of days, whereas the basis might move 1¢ either way. For example, the flat price move could be a result of a warmer-than-normal, winter whereas the basis change may be due to the fact it was colder in New Haven than New York that particular winter. A speculator might analyze basis changes to help determine the strength or weakness of a market, but this is really more of a hedger’s concern.Incorrect
The basis
In these examples, I have kept the basis fairly constant, but in reality, it can change. If a short hedger (one who sells futures) experiences a widening of the basis (where cash prices have fallen to a greater degree than futures—either cash has fallen faster or risen slower than futures), a basis loss may result. In other words, the short hedger’s cash position loss may be greater than the gain realized
on the futures side of the transaction. Or, in a rising market, the gain on the cash side of the transaction would not be as large as the loss on the futures side. Conversely, a basis gain would occur with a widening basis on a long hedge. The futures would rise in price to a greater degree than the cash. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for a long hedger (the cash falls less, or rises more, in relation to the futures). Basis gains or losses are a risk to a hedger, but they’re not nearly as big a risk as what is called flat price risk. The price of heating oil may move 20¢ per gallon in a couple of days, whereas the basis might move 1¢ either way. For example, the flat price move could be a result of a warmer-than-normal, winter whereas the basis change may be due to the fact it was colder in New Haven than New York that particular winter. A speculator might analyze basis changes to help determine the strength or weakness of a market, but this is really more of a hedger’s concern. -
Question 8 of 30
8. Question
Which of the following statements is/are not true for speculators?
I. A speculator tries to make money by buying low and selling high (or vice versa).
II. A speculator is a marketplace participant who is neither a producer nor a consumer of a commodity or financial instrument.
III. A speculator is in need of the underlying commodity.
IV. Without speculators, the system would not work as they add liquidity. Speculators often take the other side of the bids and offer in the marketplace put out by consumers.
Correct
Speculators versus hedgers
It doesn’t matter whether the user needs copper or soybean oil or to purchase yen six months hence; any market in which prices fluctuate creates price risk for commercial participants, which in turn creates the need for a hedging tool. Remember, hedgers are not trying to make a killing in the market; they wish to offset price risks. A speculator, on the other hand, tries to make money by buying low and selling high (or vice versa). A speculator is a marketplace participant who is neither a producer nor a consumer of a commodity or financial instrument. By definition, he does not have or wants the underlying commodity, and this participant could be you or me. Without speculators, the system would not work; they add liquidity. Speculators often take the other side of the bids and offer in the marketplace put out by hedgers. At times, they take the other side of a speculative bid and offer, and at times, different hedgers may be on both sides of a transaction. However, a trade cannot be completed unless someone is willing to take the other side, and if there were only hedgers and no
speculators, the system would not operate smoothly. By assuming the risks the hedgers are trying to avoid, the speculators will make money when they are right and lose when wrong.Incorrect
Speculators versus hedgers
It doesn’t matter whether the user needs copper or soybean oil or to purchase yen six months hence; any market in which prices fluctuate creates price risk for commercial participants, which in turn creates the need for a hedging tool. Remember, hedgers are not trying to make a killing in the market; they wish to offset price risks. A speculator, on the other hand, tries to make money by buying low and selling high (or vice versa). A speculator is a marketplace participant who is neither a producer nor a consumer of a commodity or financial instrument. By definition, he does not have or wants the underlying commodity, and this participant could be you or me. Without speculators, the system would not work; they add liquidity. Speculators often take the other side of the bids and offer in the marketplace put out by hedgers. At times, they take the other side of a speculative bid and offer, and at times, different hedgers may be on both sides of a transaction. However, a trade cannot be completed unless someone is willing to take the other side, and if there were only hedgers and no
speculators, the system would not operate smoothly. By assuming the risks the hedgers are trying to avoid, the speculators will make money when they are right and lose when wrong. -
Question 9 of 30
9. Question
Which of the following is/are true for limit orders?
I. A limit order prevents from paying less than the limit price on a buy order or receive more than the limit price on a sell order.
II. The drawback of a limit order is that there is no guarantee that we will get in.
III. If the market doesn’t reach the limit, we can revert to a market order.
IV. A limit order is an order to buy or sell at the prevailing price.
Correct
Limit order
When you place a limit order, you know what you will get in the worst-case scenario (you could get better), but there are strings attached. A limit order prevents you from paying more than the limit price on a buy order or receive less than the limit price on a sell order. However, unless the market is willing to meet your terms, you will not get in. The drawback of a limit order is that there is no guarantee you will get in. You could miss trades. You are not even assured that you will get in if your limit price is hit. In the preceding example, if you place a limit order to buy at “50 or better” and the market touches 50, this may be your trade, or it may be someone else’s. You can be only reasonably assured that you are in if the market trades lower than 50. It is frustrating to place an order to buy at 50, see the market trade there once and find that you’re not filled just as the market’s crossing 75. That’s not to say there isn’t a place for limit orders. I like to use them in quiet, back-and-forth-type markets so as not to give up the slippage seen with a market order. I also use them to take profits in a good position. I try to let the market reach out to my limit price. After all, if the market doesn’t reach my limit, I can always revert to a market order.Incorrect
Limit order
When you place a limit order, you know what you will get in the worst-case scenario (you could get better), but there are strings attached. A limit order prevents you from paying more than the limit price on a buy order or receive less than the limit price on a sell order. However, unless the market is willing to meet your terms, you will not get in. The drawback of a limit order is that there is no guarantee you will get in. You could miss trades. You are not even assured that you will get in if your limit price is hit. In the preceding example, if you place a limit order to buy at “50 or better” and the market touches 50, this may be your trade, or it may be someone else’s. You can be only reasonably assured that you are in if the market trades lower than 50. It is frustrating to place an order to buy at 50, see the market trade there once and find that you’re not filled just as the market’s crossing 75. That’s not to say there isn’t a place for limit orders. I like to use them in quiet, back-and-forth-type markets so as not to give up the slippage seen with a market order. I also use them to take profits in a good position. I try to let the market reach out to my limit price. After all, if the market doesn’t reach my limit, I can always revert to a market order. -
Question 10 of 30
10. Question
How can the following orders of the stop orders be useful to enter a new position in the market?
I. A buy stop is used to initiate a new position under the market on momentum.
II. A sell stop is used above the market.
III. With a stop-limit order, if the stop price is touched, a trade must be executed at the market price (or better) or held until the stated price is reached again.
IV. If the market fails to return to the stop limit level, the order is not executed.
Correct
However, when used correctly, these can be useful orders to enter a new position. While a buy stop would be used to initiate a new position above the market on momentum (if not in the market), a sell stop would be used under the market. There additionally is a variation of a stop order called a stop limit. With a stop-limit order, if the stop price is touched, a trade must be executed at the limit price (or better) or held until the stated price is reached again. The risk with the stop limit is the same as with a straight limit. In other words, if the market fails to return to the stop limit level, the order is not executed, so I normally do not recommend its use. It can, in a fast-moving market, defeat the purpose of the stop (to stop your loss).
Incorrect
However, when used correctly, these can be useful orders to enter a new position. While a buy stop would be used to initiate a new position above the market on momentum (if not in the market), a sell stop would be used under the market. There additionally is a variation of a stop order called a stop limit. With a stop-limit order, if the stop price is touched, a trade must be executed at the limit price (or better) or held until the stated price is reached again. The risk with the stop limit is the same as with a straight limit. In other words, if the market fails to return to the stop limit level, the order is not executed, so I normally do not recommend its use. It can, in a fast-moving market, defeat the purpose of the stop (to stop your loss).
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Question 11 of 30
11. Question
Which of the following is/are the features of an option?
I. An option buyer theoretically has limited profit potential.
II. Options are standardized and can be sold in the marketplace.
III. An option gives a buyer the right, but not the obligation, to buy or sell a stated quantity of a commodity (or some other “asset”) at a
specified price on or before a specific date in the future.IV. The cost of an option is called the premium. The premium is a one-time cost and represents the maximum exposure that the buyer has.
Correct
An options primer
What is an option? An option gives a buyer the right, but not the obligation, to buy or sell a stated quantity of a commodity (or some other “asset”) at a specified price on or before a specific date in the future. Options are often compared to insurance. When you buy homeowner’s
insurance, for example, you pay a premium for certain rights. These rights are yours, but the policy can limit the payoff. To some extent, this analogy works for a hedger, but there are major differences when speculating. For example, an option buyer theoretically has unlimited profit potential. Insurance policies have a stated limit. Insurance is not transferable between parties and is usually specific to a person or property. Options are standardized and can be sold in the marketplace. Actually, Exchange-traded options are quite simple.Incorrect
An options primer
What is an option? An option gives a buyer the right, but not the obligation, to buy or sell a stated quantity of a commodity (or some other “asset”) at a specified price on or before a specific date in the future. Options are often compared to insurance. When you buy homeowner’s
insurance, for example, you pay a premium for certain rights. These rights are yours, but the policy can limit the payoff. To some extent, this analogy works for a hedger, but there are major differences when speculating. For example, an option buyer theoretically has unlimited profit potential. Insurance policies have a stated limit. Insurance is not transferable between parties and is usually specific to a person or property. Options are standardized and can be sold in the marketplace. Actually, Exchange-traded options are quite simple. -
Question 12 of 30
12. Question
Which of the following is/are the advantages and disadvantages of options?
I. For option buyers, the primary advantage is the unlimited-risk feature.
II. Unlike with futures, with options, the most we can ever lose as a buyer (not as a seller) is what we pay for the option.
III. We could lose less by selling out prior to expiration, and we can even make significant profit trading options, but you have a specifically defined and maximum risk.
IV. The primary disadvantage is the premium. The premium must be paid upfront, and this cost must be recovered in part or in whole through a favorable movement in price.
Correct
Advantages and disadvantages of options
For option buyers, the primary advantage is definitely the limited-risk feature. Unlike with futures, with options, the most you can ever lose as a buyer (not as a seller) is what you pay for the option. You could lose less by selling out prior to expiration, and you could even make a significant profit trading options, but you have a specifically defined and maximum risk. Additional margin calls are not a possibility, and you can avoid sleepless nights because you know the worst-case scenario the day you initiate an option purchase. The same is not true with futures.
For option buyers, the primary disadvantage is the premium. The premium must be paid upfront, and this cost must be recovered in part or in whole through a favorable movement in price…or else you lose. When buying options, you can be correct in your market assessment, but if the market doesn’t move far enough in your favor, you still lose.
Consider this: If you buy a wheat option good for the current market price for a premium cost of $1,000, and the market goes nowhere (it stays at the same price for the life of the option), you’re out $1,000 plus fees. The market moved nowhere, and whoever sold that option to you keeps your $1,000.
To profit, the option seller only needs a stagnant market, a move in his direction, or an adverse move that does not cover the premium in full. If you buy a futures contract and hold it for the same time period in a market that goes nowhere, you’re out nothing except the commission costs. In this case, the “limited-risk” option is definitely more costly than the “higher-risk” futures contract. Of course, in this simple example, we don’t know what transpired in the interim period. The market could have sold off wildly, resulting in a margin
call or a stop loss being hit in the future and subsequently recovered. The futures trader could have been knocked out, perhaps more than once, while the options trader (not subject to margin calls) could sit it out. You see, there are no easy answers here, and we’ve only scratched the surface.Incorrect
Advantages and disadvantages of options
For option buyers, the primary advantage is definitely the limited-risk feature. Unlike with futures, with options, the most you can ever lose as a buyer (not as a seller) is what you pay for the option. You could lose less by selling out prior to expiration, and you could even make a significant profit trading options, but you have a specifically defined and maximum risk. Additional margin calls are not a possibility, and you can avoid sleepless nights because you know the worst-case scenario the day you initiate an option purchase. The same is not true with futures.
For option buyers, the primary disadvantage is the premium. The premium must be paid upfront, and this cost must be recovered in part or in whole through a favorable movement in price…or else you lose. When buying options, you can be correct in your market assessment, but if the market doesn’t move far enough in your favor, you still lose.
Consider this: If you buy a wheat option good for the current market price for a premium cost of $1,000, and the market goes nowhere (it stays at the same price for the life of the option), you’re out $1,000 plus fees. The market moved nowhere, and whoever sold that option to you keeps your $1,000.
To profit, the option seller only needs a stagnant market, a move in his direction, or an adverse move that does not cover the premium in full. If you buy a futures contract and hold it for the same time period in a market that goes nowhere, you’re out nothing except the commission costs. In this case, the “limited-risk” option is definitely more costly than the “higher-risk” futures contract. Of course, in this simple example, we don’t know what transpired in the interim period. The market could have sold off wildly, resulting in a margin
call or a stop loss being hit in the future and subsequently recovered. The futures trader could have been knocked out, perhaps more than once, while the options trader (not subject to margin calls) could sit it out. You see, there are no easy answers here, and we’ve only scratched the surface. -
Question 13 of 30
13. Question
When would a trader not in the options market consider selling options?
I. Call options are primarily sold by bullish traders. Call options are also sold by traders who expect a market to go nowhere over the specified time period.
II. Call options are sold, at times, by bearish traders who wish to receive protection, or cover a long position or gain additional income from a long position.
III. Put options are primarily sold by bearish traders, if the market moves up and remains above the strike price within the specified period, the put seller keeps the premium with no penalty.
IV. Put options may also be sold by traders who feel the market is going nowhere. At times, bearish traders who are looking for protection to cover a short position or to gain incremental income for a short position sell puts.
Correct
When would a trader not in the options market consider selling options?
• Call options are primarily sold by bearish traders: Call options are also sold by traders who expect a market to go nowhere over the specified time period. Call options are also sold, at times, by bullish traders who wish to receive protection, or cover a long position or gain additional income from a long position.
• Put options are primarily sold by bullish traders: If the market moves up and remains above the strike price within the specified period, the put seller keeps the premium with no penalty. Put options may also be sold by traders who feel the market is going nowhere. At times, bearish traders who are looking for protection to cover a short position or to gain incremental income for a short position sell puts.Incorrect
When would a trader not in the options market consider selling options?
• Call options are primarily sold by bearish traders: Call options are also sold by traders who expect a market to go nowhere over the specified time period. Call options are also sold, at times, by bullish traders who wish to receive protection, or cover a long position or gain additional income from a long position.
• Put options are primarily sold by bullish traders: If the market moves up and remains above the strike price within the specified period, the put seller keeps the premium with no penalty. Put options may also be sold by traders who feel the market is going nowhere. At times, bearish traders who are looking for protection to cover a short position or to gain incremental income for a short position sell puts. -
Question 14 of 30
14. Question
What is/are the advantages and disadvantages of selling options?
I. The primary advantage of selling options is that the seller receives the premium income paid by the buyer immediately.
II. All he needs to make money is either a quiet or stable market, or a market move away from the buyer, or a market move in favor of the buyer that is less than the premium received.
III. There is a wider range of price movements in which the option seller profits. The odds are in the seller’s favor, and this is why professionals like to buy them.
IV. The disadvantage of selling options is an unlimited risk. Selling options is the mirror image of buying options because the market can move an unspecified amount away from the strike price, the risk cannot be predetermined.
Correct
Advantages and disadvantages of selling options
The primary advantage of selling options is that the seller receives the premium income paid by the buyer immediately. All she needs to make money is either a quiet or stable market, or a market move away from the buyer, or a market move in favor of the buyer that is less than the premium received. In other words, there is a wider range of price movements in which the option seller profits. The odds are in the seller’s favor, and this is why professionals like to sell them.
The disadvantage of selling options is an unlimited risk. Selling options is the mirror image of buying options: Because the market can move an unspecified amount away from the strike price, the risk cannot be predetermined. You can think of it like a Las Vegas casino, with the option seller as the house. You know the house has the advantage, but this doesn’t mean any individual on any particular evening couldn’t make a major hit against the house.Incorrect
Advantages and disadvantages of selling options
The primary advantage of selling options is that the seller receives the premium income paid by the buyer immediately. All she needs to make money is either a quiet or stable market, or a market move away from the buyer, or a market move in favor of the buyer that is less than the premium received. In other words, there is a wider range of price movements in which the option seller profits. The odds are in the seller’s favor, and this is why professionals like to sell them.
The disadvantage of selling options is an unlimited risk. Selling options is the mirror image of buying options: Because the market can move an unspecified amount away from the strike price, the risk cannot be predetermined. You can think of it like a Las Vegas casino, with the option seller as the house. You know the house has the advantage, but this doesn’t mean any individual on any particular evening couldn’t make a major hit against the house. -
Question 15 of 30
15. Question
How does the time decay affect the options?
I. The time value of an option decreases slightly each day (provided that there is still a reasonable amount of time left before expiration).
II. The rate of this increase becomes more rapid as the option gets closer to expiration. This is termed normal time decay.
III. The normal time decay works to the detriment of the seller and the benefit of the buyer.
IV. As an option gets close to expiration time, the value becomes less and less. What matters is the relationship between the strike and the underlying commodity. This is because, at expiration, the option can only be worth something or, alternatively, nothing—and that’s it.
Correct
Time decay
All else being equal, the time value of an option decreases slightly each day (provided that there is still a reasonable amount of time left before expiration). The rate of this decrease becomes more rapid as the option gets closer to expiration. This is termed the normal time decay, and it works to the detriment of the buyer and the benefit of the seller. As an option gets close to expiration time, the value becomes less and less. What matters is the relationship between the strike and the underlying commodity. This is because, at expiration, the
option can only be worth something or, alternatively, nothing—and that’s it.
Remember, you might buy a call because you think a particular commodity will increase in price, but you could show a loss even if you are correct. This happens when the extent of the rise is insufficient to compensate for the time it takes to occur.Incorrect
Time decay
All else being equal, the time value of an option decreases slightly each day (provided that there is still a reasonable amount of time left before expiration). The rate of this decrease becomes more rapid as the option gets closer to expiration. This is termed the normal time decay, and it works to the detriment of the buyer and the benefit of the seller. As an option gets close to expiration time, the value becomes less and less. What matters is the relationship between the strike and the underlying commodity. This is because, at expiration, the
option can only be worth something or, alternatively, nothing—and that’s it.
Remember, you might buy a call because you think a particular commodity will increase in price, but you could show a loss even if you are correct. This happens when the extent of the rise is insufficient to compensate for the time it takes to occur. -
Question 16 of 30
16. Question
How does volatility affect the type of options?
I. On a percentage basis, volatility affects in-and at-of-the-money options to a greater extent than out-the-money options.
II. In-the-moneys have both intrinsic and extrinsic (that is, anything other than intrinsic—mostly time) value.
III. Intrinsic value is not affected directly by changes in volatility. Therefore, a change of 10% in volatility might change an in-the-money option’s value by 2%, whereas it would change an at-the money’s value by 10%.
IV. Out-of-the-moneys are affected most by changes in volatility because they can become profitable only when the market moves to them. A change of 10% in volatility could result in an option’s price moving by up to 50% or more. This percentage move is also easier to accomplish for out-of the-moneys because they are cheaper.
Correct
One last point about volatility: On a percentage basis, volatility affects at-and out-of-the-money options to a greater extent than in-the-money options. Here’s the reason: In-the-moneys have both intrinsic and extrinsic (that is, anything other than intrinsic—mostly time) value. Intrinsic value is not affected directly by changes in volatility. Therefore, a change of 10% in volatility might change an in-the-money option’s value by 2%, whereas it would change an at-the money’s value by 10%. Out-of-the-moneys are affected most by changes in volatility because they can become profitable only when the market moves to them. A change of 10% in volatility could result in an option’s price moving by up to 50% or more. This percentage move is also easier to accomplish for out-of the-moneys because they are cheaper.
Incorrect
One last point about volatility: On a percentage basis, volatility affects at-and out-of-the-money options to a greater extent than in-the-money options. Here’s the reason: In-the-moneys have both intrinsic and extrinsic (that is, anything other than intrinsic—mostly time) value. Intrinsic value is not affected directly by changes in volatility. Therefore, a change of 10% in volatility might change an in-the-money option’s value by 2%, whereas it would change an at-the money’s value by 10%. Out-of-the-moneys are affected most by changes in volatility because they can become profitable only when the market moves to them. A change of 10% in volatility could result in an option’s price moving by up to 50% or more. This percentage move is also easier to accomplish for out-of the-moneys because they are cheaper.
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Question 17 of 30
17. Question
Why does the option sellers take the risk of exercise and the unlimited potential risk?
I. The option seller has a head start; she receives the premium.
II. Receiving premium insulates her risk to some extent, and she makes money in less situations than the buyer.
III. The seller can make money if there is a move favorable to her position (up to when selling puts or down when selling calls).
IV. The seller also makes money in a quiet or stationary market, which is something an option buyer cannot do. Finally, she can profit even if the market moves against her, as long as it moves to a larger degree than the premium received.
Correct
The risk of exercise and the unlimited potential risk are the risks all option sellers must, by contract, accept. So, why take these risks? The reason is the option seller has a head start; she receives the premium. This insulates her risk to some extent, and she makes money in more situations than the buyer. The buyer needs a move in his favor. If he holds the option until expiration to realize a profit, the buyer needs not only a favorable move but also a move that exceeds the premium he paid. The seller can make money if there is a move favorable to
her position (up to when selling puts or down when selling calls). She also makes money in a quiet or stationary market, which is something an option buyer cannot do. Finally, she can profit even if the market moves against her, as long as it moves to a lesser degree than the premium received.Incorrect
The risk of exercise and the unlimited potential risk are the risks all option sellers must, by contract, accept. So, why take these risks? The reason is the option seller has a head start; she receives the premium. This insulates her risk to some extent, and she makes money in more situations than the buyer. The buyer needs a move in his favor. If he holds the option until expiration to realize a profit, the buyer needs not only a favorable move but also a move that exceeds the premium he paid. The seller can make money if there is a move favorable to
her position (up to when selling puts or down when selling calls). She also makes money in a quiet or stationary market, which is something an option buyer cannot do. Finally, she can profit even if the market moves against her, as long as it moves to a lesser degree than the premium received. -
Question 18 of 30
18. Question
Which of the following statements is/are true for Stock index options?
I. A trader who is bearish buys S&P 500 (or any of the other) stock index call options. A bull would, buy the puts.
II. When the premiums are low, a sale might be warranted.
III. Much of the volume in the S&P is institutional, where a portfolio manager uses the futures or options for protection, but any individual can use S&P at-the money puts for price protection.
IV. If prices rise by expiration, the purchase price and commissions are gained, and additional funds are required. This is a hedge. If you lose on the put, your stock portfolio rose. If the market falls by the same amount as the premium, you’ll get your purchase price back. In other words, you’re protecting your portfolio from a fall of greater than the premium paid. If the market falls by a greater percentage, you lose on your portfolio but gain on the put option.
Correct
Stock index options
How many times have you been right about the direction of the stock market, but your stocks went nowhere? Well, you guessed it, there’s a simple way to gamble on the stock market without having to be a stock picker. A trader who is bullish can buy S&P 500 (or any of the other) stock index call options. A bear would, of course, buy the puts. Or, when the premiums are high, a sale might be warranted. Much of the volume in the S&P is institutional, where a portfolio manager uses the futures or options for protection, but any individual can use S&P at-the money puts for price protection. They allow the buyer to sell the S&P 500 Index (the 500 biggest stocks, representing more than 80% of the U.S. market) at today’s market price. If prices rise by expiration, the purchase price and commissions are lost, but no additional funds are required. This is a hedge, however, and if you lose on the put, hopefully your stock portfolio rose. If the market falls by the same amount as the premium, you’ll get your purchase price back. In other words, you’re protecting your portfolio from a fall of greater than
the premium paid. If the market falls by a greater percentage, you lose on your portfolio but gain on the put option. Why wouldn’t a bear just sell his stocks? For long-term investors wary of a market dip, this is cheaper and easier. Selling a large portfolio of stocks would involve numerous and costly commissions. The commission on each S&P option generally is cheaper. Plus, you need not forgo dividend income on your stocks or worry about long-term capital gains taxes, and, if your stocks outperform the market in general, you have a relationship
gain. If the market declines, the investor/hedger can sell his put at a profit and hold onto the stocks. If the market rises, the stocks will be worth more, and the put has to be considered insurance that just never needed to be used.Incorrect
Stock index options
How many times have you been right about the direction of the stock market, but your stocks went nowhere? Well, you guessed it, there’s a simple way to gamble on the stock market without having to be a stock picker. A trader who is bullish can buy S&P 500 (or any of the other) stock index call options. A bear would, of course, buy the puts. Or, when the premiums are high, a sale might be warranted. Much of the volume in the S&P is institutional, where a portfolio manager uses the futures or options for protection, but any individual can use S&P at-the money puts for price protection. They allow the buyer to sell the S&P 500 Index (the 500 biggest stocks, representing more than 80% of the U.S. market) at today’s market price. If prices rise by expiration, the purchase price and commissions are lost, but no additional funds are required. This is a hedge, however, and if you lose on the put, hopefully your stock portfolio rose. If the market falls by the same amount as the premium, you’ll get your purchase price back. In other words, you’re protecting your portfolio from a fall of greater than
the premium paid. If the market falls by a greater percentage, you lose on your portfolio but gain on the put option. Why wouldn’t a bear just sell his stocks? For long-term investors wary of a market dip, this is cheaper and easier. Selling a large portfolio of stocks would involve numerous and costly commissions. The commission on each S&P option generally is cheaper. Plus, you need not forgo dividend income on your stocks or worry about long-term capital gains taxes, and, if your stocks outperform the market in general, you have a relationship
gain. If the market declines, the investor/hedger can sell his put at a profit and hold onto the stocks. If the market rises, the stocks will be worth more, and the put has to be considered insurance that just never needed to be used. -
Question 19 of 30
19. Question
Which of the following statements is/are true for buying options to protect futures?
I. Buying options to protect futures involves buying a call with a long future.
II. Buying options to protect futures involves buying a put with short futures.
III. Creating synthetic options means a put combined with a long future is similar to a call.
IV. Creating synthetic options means a call in conjunction with the short futures is similar to a put.
Correct
Buying options to protect futures
Buying options to protect futures involves buying a put with long futures or buying a call with short futures. This strategy is also known as creating synthetic options because a put combined with long futures is similar to a call, and the call in conjunction with the short futures is similar to a put. You can make a case that if you buy an at-the-money call option while simultaneously holding a short futures position (synthetic put), or you buy a put option while simultaneously holding a long futures position (synthetic call) that the overall position will act just like a put or a call (so why bother?). Because this can be a better strategy since it gives you added flexibility.Incorrect
Buying options to protect futures
Buying options to protect futures involves buying a put with long futures or buying a call with short futures. This strategy is also known as creating synthetic options because a put combined with long futures is similar to a call, and the call in conjunction with the short futures is similar to a put. You can make a case that if you buy an at-the-money call option while simultaneously holding a short futures position (synthetic put), or you buy a put option while simultaneously holding a long futures position (synthetic call) that the overall position will act just like a put or a call (so why bother?). Because this can be a better strategy since it gives you added flexibility. -
Question 20 of 30
20. Question
Why professionals sell options generally to the public?
I. The professionals hedge the sales of options with a ratio of long futures, but the public generally likes to purchase premium.
II. The advantage of selling options is that you can capitalize on the time decay of options.
III. The premiums the people pay for options eventually rise to option heaven, the option seller looses these premiums.
IV. Covered option writing can allow you to take advantage of the decaying option premiums just like the professional sellers, but it is less risky in a volatile market. It basically involves selling call options and buying futures or selling puts and shorting futures.
Correct
Covered option writing
As we’ve discussed, the advantage and attraction of buying options are that your risk is limited and predetermined, and the profit potential is unlimited. However, the majority of options expire worthless, and the premiums eventually disappear. Therefore, buying options is generally a losing proposition. This is not to say that you cannot make good money in a major bull or major bear market, but be advised that professionals primarily sell options (generally to the public). They might hedge these sales with a ratio of long or short futures, but the public generally likes to purchase premium. The advantage of selling options is that you can capitalize on the time decay of options. Because the premiums that people pay for options eventually rise to option heaven, the option seller gains these premiums. While writing options is generally a winning strategy, the big disadvantage is that the risk is unlimited, while the profit potential is limited to
the premiums received. When option premiums are high, the general rule of thumb is that it is better to sell options than to buy them.
The advantage of futures is the unlimited profit potential, but the risk is theoretically unlimited also. You should, therefore, use risk-management techniques (stops). Stops are not foolproof, but they generally work efficiently.
The main problem with stops are that they can be filled away from your intended risk level at times and in a volatile market you can be stopped out only to have the market eventually go back your way. On the other hand, if you do not have stops, you cannot predetermine what your risk is. Covered option writing can allow you to take advantage of the decaying option premiums just like the professional sellers, but it is less risky in a volatile market. It basically involves selling call options and buying futures or selling puts and shorting futures. For example, in a recent bull soybean market, I bought the November beans at $18.00 and sold the 1800 calls for 60¢. This gave me 60¢
in downside protection. At expiration, if the market was anywhere above $17.40, I would still profit from this trade. If the market was anywhere above $18/bushel at expiration, I would keep the 60¢, or $3,000 gross per covered contract position —not a bad profit.Incorrect
Covered option writing
As we’ve discussed, the advantage and attraction of buying options are that your risk is limited and predetermined, and the profit potential is unlimited. However, the majority of options expire worthless, and the premiums eventually disappear. Therefore, buying options is generally a losing proposition. This is not to say that you cannot make good money in a major bull or major bear market, but be advised that professionals primarily sell options (generally to the public). They might hedge these sales with a ratio of long or short futures, but the public generally likes to purchase premium. The advantage of selling options is that you can capitalize on the time decay of options. Because the premiums that people pay for options eventually rise to option heaven, the option seller gains these premiums. While writing options is generally a winning strategy, the big disadvantage is that the risk is unlimited, while the profit potential is limited to
the premiums received. When option premiums are high, the general rule of thumb is that it is better to sell options than to buy them.
The advantage of futures is the unlimited profit potential, but the risk is theoretically unlimited also. You should, therefore, use risk-management techniques (stops). Stops are not foolproof, but they generally work efficiently.
The main problem with stops are that they can be filled away from your intended risk level at times and in a volatile market you can be stopped out only to have the market eventually go back your way. On the other hand, if you do not have stops, you cannot predetermine what your risk is. Covered option writing can allow you to take advantage of the decaying option premiums just like the professional sellers, but it is less risky in a volatile market. It basically involves selling call options and buying futures or selling puts and shorting futures. For example, in a recent bull soybean market, I bought the November beans at $18.00 and sold the 1800 calls for 60¢. This gave me 60¢
in downside protection. At expiration, if the market was anywhere above $17.40, I would still profit from this trade. If the market was anywhere above $18/bushel at expiration, I would keep the 60¢, or $3,000 gross per covered contract position —not a bad profit. -
Question 21 of 30
21. Question
Which of the following statements is/are true for Vertical call spreads?
I. Two options of the different months but with the same strike prices that are spread against each other.
II. The vertical call spread is bullish, and the vertical put spread is bearish.
III. Bull spreading calls offer the best of both worlds. The risk, as in buying options, is strictly limited. We lower our overall cost by benefiting from the time decay of selling premium. We are selling premium on the greater out-of-the-money option, which is more likely to expire worthless than the lower-priced option.
IV. No premium cost is there, and the broker incurs double commissions.
Correct
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.Incorrect
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. -
Question 22 of 30
22. Question
What does a 2:1 ratio spread involve?
Correct
Ratio spreads
A 2:1 ratio call spread involves buying one lower-priced call and selling two higher-priced calls.Incorrect
Ratio spreads
A 2:1 ratio call spread involves buying one lower-priced call and selling two higher-priced calls. -
Question 23 of 30
23. Question
Why it is advisable to avoid deep in-the-money options?
I. If an option is deep in the money, it cuts down on your leverage and lower your risk.
II. The risk is still limited, we are 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.
III. When buying deep in-the-money options, we tie up a lot more money that can be used for other opportunities.
IV. The biggest advantage to an option seller is time decay, and deep in-the-money options have more time value; therefore, you have less to gain the easy way and more risk with the intrinsic value component.
Correct
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!Incorrect
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! -
Question 24 of 30
24. Question
Which of the following is/are true for fundamental analysis?
I. Fundamental analysis is the study of supply and demand.
II. The fundamentalist says that the cause and effect of price movement is explained by supply and demand.
III. Fundamentalists are able to trade the courage of their convictions and are not shaken out as easily during false market movements.
IV. Fundamentalists are better able emotionally to maximize positions because fundamentals can take a less time to change. Fundamentals can be powerful and allow a trader to stay with a position longer than he otherwise might stay.
Correct
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.Incorrect
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. -
Question 25 of 30
25. Question
Which of the following is not comes under the major futures markets groupings?
Correct
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
• MetalsIncorrect
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 -
Question 26 of 30
26. Question
Which of the following is/are the major industrial metal fundamentals?
I. 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 higher prices.
II. 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.III. 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.”
IV. Inflation: The industrial metals have, at times, been called “the poor man’s gold,” and they heat up in an financial environment.
Correct
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.Incorrect
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. -
Question 27 of 30
27. Question
Which of the following is/are the major metals fundamentals?
I. 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.
II. In times of stability, gold is considered a store of value. War or a loss of confidence in traditional investments can cause a shift of funds into gold.
III. As income growth increases in the growing economies, so has gold demand decrease. In the long run, the prices of gold and all other precious metals are sensitive to inflation.
IV. 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.
Correct
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.Incorrect
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. -
Question 28 of 30
28. Question
Which of the following is/are the major fundamentals for the softs?
I. 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. 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.
II. 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.
III. Coffee consumption is believed to be more elastic, with a major price decrease needed to curtail demand.
IV. Crop yields: Weather, disease, insects, and political and economic conditions in the producing countries all affect production rates.
Correct
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.Incorrect
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. -
Question 29 of 30
29. Question
Which of the following reasons states the need of spreads?
I. Some traders who trade only spreads because they feel spreads are the best way to limit some of the risks inherent in derivates.
II. The main purpose of spreading is to reduce risk.
III. When a spread is entered, 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.
IV. When we put on a spread, we buy one contract while simultaneously selling another. We 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.
Correct
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.Incorrect
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. -
Question 30 of 30
30. Question
Which of the following is true for Intramarket spreads?
I. Intramarket spreads consist of buying one month in a particular commodity and simultaneously selling the same month in the different commodity.
II. When you sell the near month and buy the distant, it is called a bull spread.
III. A bear spread is the mirror image of the bull spread.
IV. In a bull spread, we are predicting that the near month either will rise faster than the distant or fall slower. Either outcome is profitable.
Correct
Intramarket spreads
Intramarket spreads consist of buying one month in a particular commodity and simultaneously selling a different month in the same commodity.Incorrect
Intramarket spreads
Intramarket spreads consist of buying one month in a particular commodity and simultaneously selling a different month in the same commodity.