Derivatives Fundamentals and Options Licensing Course (DFOL) Practice Questions And Answers

How can you tell a breakaway from a common gap? Common gaps are filled fairly quickly. Breakaway gaps are not filled for a long time, sometimes never for the life of a contract. They signify the start of a new and major trend move. Many times they form out of consolidation or during blow-off highs or lows. The breakaway day is accompanied by greater-than-normal volume, usually at least 50% greater than the average volume of the preceding two weeks. These are significant and powerful tools that you should be alert for constantly. Particularly, watch for them when a market appears to be “cheap” or “expensive.” The market could be based on a major bottom or climaxing for a major top.

Oversold is the antonym: The market is too low, running out of sellers (at least for the current time period), and ready for a bounce. Oversold is not a scientific term and is bandied about somewhat arbitrarily. The RSI attempts to quantify the degree of oversold or overbought.

What causes a market to invert? In most cases, an inverted market is the product of a perceived or real near-term shortage of the commodity in question. This can be caused by weather. For example, cold weather tends to push the nearby natural gas over the back or could even push the nearby cattle contracts above the backs because cattle do not gain weight efficiently in cold weather and could conceivably be “pushed back”—not ready for market in a timely manner. Inversion could be caused by a mining strike, a government program, big near-term export demand, or a classic short squeeze—actually, any number of things. The important point here is that the spreads can give you important clues about the strength or weaknesses within a market.

A reverse pivot occurs when a setup that is not triggered leads to a confirmed signal in the opposite trend direction. My experience has been that reverse pivots
more often than not lead to powerful signals with above-average reward-to-risk ratios.

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.

Stop orders
Stop orders, or stops, are used in two ways. The most common method is to cut a loss on a trade that is not working (also known as a stop-loss order). A stop is an
order that becomes a market order to buy or sell at the prevailing price only if and after the market touches the stop price. A sell stop is placed under the
market, a buy stop above the market.

Overbought is generally considered to be a value in excess of 80, and oversold is less than 20.

Point and figure charts
The point and figure (P&F) is another type of price charting; the unique thing about P&F is that it ignores time. Time is irrelevant; only price matters. Xs and
Os indicate price signals. A P&F chartist uses Xs to illustrate rising prices and Os for falling prices. As long as the price is rising, Xs are added. Os come into
play when they are dropping. The decision to start a new column of Xs or Os is based on the market making a price change of a certain amount designated by the technician. This would be a box. The technician also must designate (in addition to the size of each box) what determines a reversal. For example, a popular reversal size is three boxes. So, if you use a scale of 10 points for cattle, a reversal size would be 30 points. The values for the box and reversal are arbitrary, depending on how sensitive the trader wants the P&F chart to be.
The larger the box size and reversal values, the less sensitive the chart is and vice versa. A 1¢ box for wheat is obviously more sensitive than a 10¢ box. If the
chart is too sensitive and the boxes too small, you increase the chances of being whipsawed by insignificant fluctuations. If the boxes are too large, you miss out
on significant portions of some moves and take too much risk. Figure 8.27
illustrates a typical P&F chart.

Spreads—a valuable forecasting tool
I’ve found that by monitoring the spread of action in many of the actively traded physical commodities, a trader can get valuable clues about how bullish or bearish a market is. Spreads also can be used to predict the market path of least resistance. Typically, commodity futures markets are in “carrying charge” or “normal” configurations. (In London, they would say the market is in contango.) This is when the distant months sell at a higher price (or premium) to the closing months.
This configuration is called an inverted market. (In London, it’s called backwardation.) What causes a market to invert? In most cases, an inverted market is the product of a perceived or real near-term shortage of the commodity in question. This can be caused by weather. For example, cold weather tends to push the nearby natural gas over the back or could even push the nearby cattle contracts above the backs because cattle do not gain weight efficiently in cold weather and could conceivably be “pushed back”—not ready for market in a timely manner. Inversion could be caused by a mining strike, a government program, big near-term export demand, or a classic short squeeze—actually, any number of things. The important point here is that the spreads can give you important clues about the strength or weaknesses within a market.

Common gaps: The majority of gaps are more likely to be filled sooner than later. Most daily gaps are filled during the same trading session, and of those that aren’t, more often than not, they are filled within a day or two. Because these are the most common variety, they are known as common gaps. They might occur, for example, as a result of a government report, but the news usually is not strong enough to change the major trend, and the gap is filled quickly. Common gaps are seen quite often in thin, or low-volume, markets and are rarely significant. The trick is to be able to differentiate the common variety from the other three. The other three varieties are important technical tools that have powerful forecasting abilities.

Measuring gaps: A measuring gap is found at approximately the midpoint of a powerful trend move. Such a gap forms one day, often on news, but unlike with a common gap, the market continues on its way without filling the gap. Once again, volume is usually large. Measuring gaps serve to trap many players who are on the wrong side even more deeply in the muck, and these traders provide some of the fuel for the next leg up or down. The interesting thing about these gaps is that they tend to occur when a move is just about half over. If the breakaway came at 100 and the measuring is at 140, you can project that this move will run to about 180. The measurement rule is certainly not written in stone. At times, there will be more than one measuring-type gap in powerful moves, perhaps one at 33% of the move and another when the move is about 60% to 67%. However, the 50% rule is usually pretty close, so it can help you determine approximately where you are in the move. Exhaustion gaps can do this, too. (See Figure 8.20.)

How can you determine whether a gap is of the exhaustion variety? Unlike with breakaway or measuring gaps, an exhaustion gap will be filled fairly quickly. More commonly, the market will churn for three to five days, but it will generally be filled fairly quickly—sometimes the next day. Many times, the high of the exhaustion top day will not be exceeded, or with a downside, there will be no lower lows. The volume will be high, but it was probably high in the days preceding the exhaustion day, too. Like breakaway gaps, exhaustion gaps are powerful indicators. Keep your exhaustion gap antenna up when a market becomes wild-eyed after a long run-up or panic-stricken after a long run down. Remember, it is always darkest before the dawn and brightest just before the sun starts to recede.

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.

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.

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!

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

The trader seeks to profit from the net premium received is the appropriate statement regarding bull put.

Straddle vs. spread
A long straddle or strangle will profit from extreme price volatility in either direction. The expectation is that the price differential will offset the premium paid to establish the position. A short straddle or strangle will profit from little or no volatility, and traders seek to profit from the premium received.

Options and futures once breakeven point is reached
The futures position offers unlimited (within the expiry period) upside potential at all prices either above (long) or below (short) the market price at inception. Options also offer unlimited (within the expiry period) upside potential, but only after the strike price is exceeded. The key difference between the two strategies is related to risk. Options can expire worthless if prices move adversely, while futures will experience losses.

Long call and long futures
The table below shows the profitability, ROI, and breakeven point for a long call and a long futures in various pricing scenarios. Note that there are continuing losses for futures as prices fall, while the maximum loss for a call is limited to the premium.