Futures Licensing Course (FLC) Practice Questions And Answers

Knowledge
The stakes are high, and the competition is intense. You need a well-thought-out and thoroughly researched trading plan before you begin, and you need to do your homework. Your plan should always have a mechanism to cut the losses on the bad trades and to maximize profits aggressively on the good ones. You must be organized and remain focused at all times. If your plan is a good one, you need the consistency to stick with it during down periods.
My personal goal is to make money daily, but that is not always possible, so I try not to lose too much on losing days. It is a constant trial to maintain the vigilance necessary to not to let good judgment lapse. If you are a novice, it makes sense to “paper trade” before you trade for real. If you are trading currently, you should keep a logbook. Log your triumphs and your failures. You want to avoid making the same mistakes again, but I must warn you, all traders repeat mistakes. At the very least, learn not to make the mistakes so often. By keeping a record of what you do right and what you do wrong, you can identify areas of weakness and areas of strength. If you are not totally prepared on any given day, don’t trade. You can’t “wing it” in this business because the competition will eat you up. Over time, you will develop what I call a “trader’s sense.” You will know when a trade doesn’t feel right, and when this happens,
the prudent thing to do is to step aside. You cannot ignore the danger signals, and when they occur, you must act without hesitation. You must have a game plan and stick to it, but the paradox here is that you also need to be flexible. At times, it is best to do nothing, and you need to fight the urge to play for every pot. And, as I said before, stay focused. At times, I’ve been distracted by day trades and missed the big move because I missed the big picture. By the time I finally saw the light, it was too late.

The size of a contract determines its value. To calculate how much money you could make or lose on a particular price movement of a specific commodity, you need to know the following:
• Contract size
• How the price is quoted
• Minimum price fluctuation
• Value of the minimum price fluctuation

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.

When unexpected news occurs (news that the market has not had time to prepare for) and the market opens in a wide range or “gaps” lower or higher, sell out your longs or cover your shorts and wait. Watch the market for 30 minutes to an hour. If the market opened sharply lower with heavy selling and was not able to trade much lower than that, it’s into support and you can buy it with a tight risk point. Watch the market closely at this point and note the tone of the rally. If it’s small and the market is able to again fall under the levels made when the bad news came out (or rise above the levels made when the good news came out), it’s safe to assume the market is going lower (higher).

When the closing price turns down and under the average, a sell signal is generated.
You can connect each day’s value on a chart to produce a line. You can chart this line and overlay it onto a price chart to generate trading signals. A simple trading program would look like this: As long as the line on any particular day is under the closing price, the trader would stay long because the SMA has determined that the trend is up. After the line crosses over the closing price, the trader would go short because the trend has turned down. If the position is long
and the line crosses over the closing price, the trader would reverse the position by selling double the number of contracts owned. The problem with this simple
trading program is if you do this every time the line crosses price (especially when using shorter-term averages), you can easily get “whipsawed” (bounced back and forth, with small losses and commissions eating you up). A market can trade in a wild range, moving up and down wildly in the same session, but as I have mentioned before, I believe that the closing price is the most significant.

Entering a new pivot trade from the long side requires three steps:
1. Setup bar
2. Buffered entry price
3. Triggered entry

If prices are in a downtrend and OI is rising, this is a bearish sign
The bears are in charge of this case. They are adding to their positions, and they are the ones making money. Weaker longs are possibly being stopped out, however, new buyers are taking their place. As the market continues to fall, the shorts get stronger, and the longs get weaker. Another way to look at the first two rules is that, as long as the OI is increasing in a major trend, it will have the financing it needs to draw upon and prosper.

Overbought basically means the market is too high in the respect that it’s running out of buyers; in effect, it’s about to fall of its own weight. 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.

How do you use the RSI? When this number gets too small or too large, it is time to put your antenna up. The market could be getting close to a reversal point. Some traders attempt to buy when the RSI wanders into oversold range and sells in the overbought range. My opinion is that if you attempt to do this, you better have deep pockets. At times (range-bound markets), this can be an excellent way to pick tops and bottoms. However, in the major moves and at extremes (the most profitable time for the trend follower), the RSI can remain in the extreme ranges for long periods of time and for quite a few points. (And, hey, it’s “only” points, right?) This is the major drawback of the RSI: It works in normal markets, but when the market is in the blow-off or panic stage, it can remain in overbought or oversold territory for an extended period and become quite costly.
Still, I do believe the RSI is a useful tool, but only when used in conjunction with other indicators. You need to know what type of market you are in (trading range or trending, young or mature). If you can determine this, the RSI can help you identify the point in the life cycle of the market. The RSI tends to get high in the mature stages of a bull market and low in the mature stages of a bear, but there is no magic number that signals the bottom. In fact, I’ve found it is a good
practice to watch for the RSI to turn up after it falls under 25 to signal a bottom and vice versa for the bull. Yet, even this tactic tends to lead to numerous false and money-losing signals because the RSI is a coincident indicator. It moves with a price. A minor upswing has to turn the RSI up.

There are four reasons that technical analysis makes sense:
1. “Footprints in the sand”: The smart money (who are generally the big players) cannot hide. They might be better informed, but their buying or selling has to show up in price, volume, and open interest.
2. The market discounts all fundamentals in price.
3. History does repeat, and if you don’t learn from it, you are bound to fail.
4. Markets do move in trends, and these trends are more likely to continue than not. It is the goal of technicians to determine the trend.

The rule of thumb is that the more points you have connected, the more “valid” the trendline. But here’s the rub: The more “valid” the trendline, by definition, the more price data you have to use, and, therefore, the older the trend and the closer it is to its inevitable conclusion. A broken trendline (that is, price action moving below an up trendline or above a down trendline) is a danger signal that the trend has reversed (see Figure 8.2). This is how technicians use trendlines. When an up trendline is broken, longs should be liquidated and new shorts established. Shorts should do the opposite when a down trendline is broken. Many traders place stops just under an up trendline or just above a down trendline to exit positions. If a trend is of significant duration, a trailing stop can be used, where the risk is reduced gradually daily as the stop loss is moved in the direction of the prevailing trend. In this way, the first risk is the greatest risk. The objective is first to achieve break-even, and then if everything goes according to plan, a modest profit is locked in. Over time, additional profits are locked in until the trendline is finally broken. The best and most reliable trendlines are older and, therefore, by definition, longer.

Trend channels
Prices in a classic trend commonly tend to trade roughly within a channel. A channel is identified by constructing a line parallel to the major trendline. If a market is trending higher and an up trendline has been constructed, the top line of the channel is drawn by connecting progressive highs. In a downtrend, a parallel to the down trendline is drawn, connecting progressive lows and a channel is born (see Figure 8.5). As long as the market remains within the channel, for the most part, the market is behaving normally during a trending type period. Nimble traders look to buy on the trendline and sell toward the upper channel line (assuming that they’re in an uptrend). Active traders might also look to reverse at the channel lines, but this generally is not recommended, because they would be fighting the trend.
Markets will eventually trade outside the bounds of the channel. This can be a significant clue to subsequent market action. The general rule of thumb is that when a market trades above the upper channel line (in an uptrend) or below the lower channel line (in a downtrend), odds are that the market is entering an accelerated phase in the direction of the major trend. In other words, a significant change in the normal supply and demand balance has taken place. With bona fide breakouts of channels, the market tends to move faster, with price action becoming more dramatic. Stops can be tightened, positions can be pyramided, and your “antenna should be up” for any signs of a subsequent trend reversal. The accelerated phase of any market can be the most profitable and most exciting time to play, but it also can be the shortest. Don’t fight it; go with it but remain alert. If acting right, after it has broken out, the market should not fall back into the channel because this would be the place to exit and reevaluate.

The mirror image of support, the ceiling, is called resistance. This is a level where the market has a hard time moving higher or where a market has trouble getting above a certain point. If cotton rallies to 10000, then tail off to 9700 and back up to 9995, and it does this more than once, this is the level (at least temporarily) of resistance. In other words, resistance is an area in which the selling interest is greater than the demand.
Support and resistance levels can be drawn graphically by using a horizontal line on a bar, chart connecting the floor points, in the case of support, and ceiling points, in the case of resistance. These are important levels that indicate the areas you would expect a market to hold or to fail. As with trendline points, traders are cognizant of where support and resistance levels are. As a result, they can become a self-fulfilling prophecy, at least in the short run. If a market continues to fail at a certain resistance level, the sellers become bolder every time that price is reached, and the buyers assume that this is the place to exit.

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.

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.

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.

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).

NFA membership requirements
In 1978, legislation that amended the Commodity Exchange Act (CEA) was passed. It provided for mandatory membership in at least one futures association that would act in a regulatory capacity on behalf of the Commodity Futures Trading Commission (CFTC). Since the National Futures Association (NFA) is the only such registered futures association, the legislation effectively made NFA membership mandatory.

Customer information required to establish trading account
National Futures Association (NFA) Compliance Rule 2-30 (the know your customer rule) requires that the risks of futures trading be disclosed to customers before a trading account is opened. The minimum information that must be provided by customers in order to establish a trading account is as follows:
• the name, address, and principal occupation or business of the customer
• the current estimated annual income and net worth of the customer (if the customer is an individual)
• the customer’s net worth or net assets and current estimated annual income; or, if current income is not available, the customer’s annual income for the previous year (if the customer is not an individual)
• the approximate age and/or date of birth of the customer (if the customer is an individual)
• an indication of the previous investment and futures trading experience of the customer
• other information considered to be reasonable and appropriate by the member or associate in order to appropriately disclose the risks of futures trading to the customer