Series 3 Exam Questions & Answers (SIA Instructor Verified)

The short answer is No. The series 3 is one of the only exams that requires candidates to pass both the general section and the regulation portion of the exam. Candidates must score 70 percent or higher in both sections to pass the exam. Even if a candidate passes one section by a margin large enough that the combined score on the overall exam would exceed 70 percent, the result will still be a failing score. This is something that has caused candidates a great deal of frustration.The NFA has set the rules for the exam and the exam is administered through FINRA on their behalf. Another unique feature of the series 3 is the use of true and false questions. These tend to be more challenging than one would think. The test writers are quite skilled at creating questions that are difficult to parse through. Should you find yourself having passed one section and not the other, be sure to study both sections to prepare for the retake. If you ignore the section you did well on you may find you pass the section you failed the first time and fail the section you passed. Study hard, stay focused and good luck on your exam.

You are indeed correct. The term basis is used in a variety of ways to detail several very important series 3 concepts. First off, the term basis is used to describe the cash commodity. So for a wheat contract the basis is cash wheat. Next, it is used to note the standard grade of the cash commodity. The basis grade for wheat is number 2 wheat. This is the quality that is expected to be delivered. Finally, basis is the spread between the price of the cash commodity and the price of the front month futures contract. So if cash wheat is priced at $6.12 per bushel and the front month contract was trading at $6.20, the basis would be 8 cents under. The market is regularly quoted on its basis. If a question on your exam stated that the soybean market is 4 cents under you would know that the price of the cash commodity would be trading at a price 4 cents lower than the front month futures contract. Of course there are a significant number of questions that talk about a change in the basis. These questions seem to be the most challenging for test takers. Keep in mind that a change in basis simply reflects a change in the spread between the price of the cash commodity and the front month futures price. When the basis becomes stronger in a normal market the spread is less negative and contracts. If corn went from 8 cents under to 5 cents under, we would say that the basis strengthened. -5 is less negative than -8. The basis becomes weaker when it becomes more negative. If Crude went from $7 under to $12 under the basis would have weakened. Check out the section in our videos that covers everything you need to know.

Yes, the tax treatment for futures and options on futures are truly unique. The tax code is nothing like the way the IRS taxes equity transactions. Futures contracts and options on futures are classified as Section 1256 contracts. This means that they are subject to the 60/40 rule. 60 percent of the gain or loss will be taxed as a long term gain or loss. The remaining 40 percent will be taxed as a short term gain or loss. These rules apply for all closedcontract positions even if the contracts were established and offset in a very short period of time and in the same calendar year. Let's take a look at an example. assume a speculator goes long  2 December silver at $53 per oz. and 2 weeks later off sets the contracts at a price of $58 per oz. The investor made $5 per ounce. With each contract covering 5,000 ounces, the investor made a total of $50,000 Under the 60/40 rule $30,000 will be taxed as a long term capital gain and $20,000 will be taxed as a short term capital gain. This is not the only unique tax treatment of futures contracts. All open contract positions will be marked to the market and assumed to have been closed out for tax purposes every year on December 31st.  Let's assume an investor had an open futures position with a cost basis of $50,000 and positive open trade equity on the position of $20,000 on December 31st. The positive open trade equity would be taxed as follows:  $12,000 of the unrealized gain would be treated as a long term capital gain and $8,000 would be treated as a short term capital gain. Going into the new year the investor’s cost basis would be adjusted upward to reflect the mark to the market taxation applied to the position. For the new year the investor would have a cost basis of $70,000.

Series 3 test takers can certainly expect to see questions regarding delta hedges on the exam. Remember that an option’s delta is its rate of change or its participation in the price movement of the underlying futures contract. An option contract with a delta of 20 would participate in 20 percent of the price change of the underlying futures contract. As the farmer is looking to hedge their corn crop of 200,000 bushels the first thing we need to do is to calculate the number of futures contracts required to hedge the crop. Each corn futures contract covers 5,000 bushels. Therefore, the farmer would need to sell 40 futures contracts to hedge the crop against a decline in prices. The farmer can also hedge the crop using options. As a producer of corn the farmer is a short hedger. Instead of selling futures the farmer could purchase put contracts on corn futures. Since the question asked about using options with a delta of 20, we must now calculate the number of put contracts needed to hedge the 200,000 bushels of corn. Because the options delta is 20 it takes 5 contracts to hedge the price move of 1 futures contract. So to determine the number of put contracts required we multiply the number of futures contracts required to hedge the crop by 5. In this case the farmer would have to purchase 200 put contracts to hedge the crop.

The structure of the futures market is a key concept to master. It is critical that you understand the events that impact market structures and what it means in relation to the basis for the underlying commodity. Let's start with a normal market. A normal market is one where the price of the cash commodity is lower than the price of the front month contract. In a normal market each of the distant month contracts will be priced at successively higher prices. For example, if cash soybeans are priced at $5.12 per bushel and the front month contract of September is trading at $5.15 and December soybeans are trading at $5.20, this is a normal market. A normal market is in the state of contangio which simply refers to the pricing relationship between the cash commodity and the available futures contracts for each month. A normal market is also known as a carrying charge market. Normal market conditions exist when supply of the commodity is abundant. When markets enter a state of backwardation, a supply shortage or shock is reflected in the pricing of the market. During states of backwardation, the price of the cash commodity is priced higher than all of the futures contracts. During backwardation the front month contract is trading higher than the deferred  contracts and each subsequent delivery month is trading at lower prices as the market anticipates the shortage be resolved and the supply to return to normal. Imagine if an unexpected cold snap moved through the corn belt and a substantial amount of this season’s harvest was wiped out. Users of corn would be scrambling to ensure that they can secure the corn on the cash market to meet their needs. As a result the price of cash corn would skyrocket and would exceed the price of all of the futures contracts. In this case we could see a market where cash corn was priced at $7.10 per bushel and the front month priced at $6.95 per bushel with each of the deferred contracts being priced at successively lower prices. Remember in this context the basis refers to the spread between the price of the cash commodity and and the price of the front month contract. In our normal market when cash soybeans are priced at $5.12 per bushel and the front month contract of September is trading at $5.15 the basis would be quoted as 3 cents under. In our corn market subject to a supply shock with cash corn was priced at $7.10 per bushel and the front month priced at $6.95 per bushel the basis would be quoted at 15 cents over.

The value of one currency relative to another constantly fluctuates. The U.S. dollar is the benchmark against which the value of all other currencies is measured. During any given point, one U.S. dollar may buy more or less  of another country’s currency. Businesses engaged in international trade can hedge their currency risks through the use of foreign currency futures.

Foreign currency futures may also be used by investors to speculate on the direction of a currency’s value relative to the U.S. dollar. As the value of another country’s currency rises, the value of the U.S. dollar falls. As a result, it would now take more U.S. dollars to purchase one unit of that foreign currency. Conversely, if the value of the foreign currency falls, the value of the U.S. dollar will rise, and it would now take fewer U.S. dollars to dollars to purchase one unit of the foreign currency. The values of foreign currencies are inversely related to each other. Foreign currency futures trade on the Chicago Mercantile Exchange. The exchange sets the amount of the foreign currency covered under each contract and the delivery month. Foreign currency futures settle in the exchange or delivery of the currencies. Businesses and investors will trade foreign currency futures for very different reasons. A business will trade foreign currency futures to manage its foreign currency risk. An importer will purchase foreign currency futures for the currency of the country where it purchases products to reduce the risk of that country’s currency rising in value in relation to the U.S. dollar. If the country’s currency becomes stronger, it will take more U.S. dollars to purchase the same amount of the foreign currency. As a result, the cost to the importer will rise. Alternatively, in the case of an exporter a fall in the value of a foreign currency relative to the dollar would cause the exporter to realize a lower sales price for their products once the payment in the foreign currency is converted into U.S. dollars. As a result, the exporter, to manage foreign currency risk, will sell futures on the foreign currency.

We see this question a lot. Market if touched orders are placed by investors to enter or exit contracts, The investor wants the order to be executed if the market trades at or through a set price. A MIT order becomes a market order to purchase or sell the contracts at the next available price if a quote appears that would allow for its execution. An MIT order to buy futures contracts would be entered below the market and would be elected if the futures contract trades at or through or is offered at the trigger price. When September wheat is trading at 1.54, an MIT order to buy futures may be entered as follows:

Buy 5 September wheat at 1.50 MIT

The above order will be executed at the market if September wheat trades at 1.50 or lower or if September wheat is simply offered at 1.50. A buy order entered as a market-if-touched order could be used by an investor who wishes to establish a long position or by an investor who is looking to offset a short position. An MIT order to sell futures contracts would be entered above the market and would be elected if the futures contract trades at or through or is bid at the trigger price. When September corn is trading at 4.65 An MIT order to sell futures may be entered as follows:

Sell 8 September corn at 4.75 MIT

The above order will be executed at the market if September corn trades at 4.75 or higher or if September corn is bid at 4.75. A sell order entered as a market-if-touched order could be used by an investor who wishes to establish a short position or by an investor who is looking to offset a long position. An order that is entered as a market-if-touched order is also known as a board order.

all deliveries must be made to an approved warehous in order to ensure futures contracts are settled according to the terms and conditions of the contract. Delivery cannot be made to any other location. Every exchange must have at least one warehouse approved to accept deliveries to settle futures contracts. The warehouse must inspect the delivery to ensure that the commodity that is delivered is the correct quantity and quality. Once inspected the warehouse will certify that it has received the commodity in good condition and as expected. At this point the commodity being delivered becomes the property of the buyer. The warehouse will await further instructions from the owner as to what should be done with the commodity. The owner may elect to have it stored at the warehouse and pay the storage and insurance charges. Or may elect to have the commodity picked up and taken on to the owners location. Delivery is NEVER made directly to the person who is long the contract. The seller of the contract is in control of the contact. If the seller of the contract wants to deliver the commodity, the seller will file a notice of intent to deliver with their FCM. The seller will detail the quantity and quality of the commodity to be delivered. If the exchange has more than one approved warehouse the seller will determine where the delivery will take place.

The short answer to this question is no. Investors who purchase and sell futures contracts never directly interact with the clearinghouse. When investors purchase or sell futures contracts they are required to deposit the required margin with their futures commission merchant. Only FCMs who are members of the clearinghouse will transmit funds to the clearinghouse. Most clearinghouses operate on a continuous net settlement basis. This means that FCMs will net all of their long and short contracts for the same commodity and forward the required margin to the clearinghouse. For example, As a trading day is coming to a close ABC Futures Commission Merchant is reviewing its activity for the day. It sees that customers have opened 320 new long contracts in June crude. It sees that other customers of ABC have opened 80 new short contract positions in June crude. As a result of this activity ABC will forward the margin for 240 contracts to the clearinghouse. The funds must be there prior to the opening of the next trading day. When customers of an FCM offset a large number of contacts it may result in the FCM having excess margin at the clearinghouse.  In these cases the FCM may withdraw the excess funds from its account. It is important to note that even though the FCM only transmits the net margin to the clearinghouse, it is required to collect the margin from all customers.

Options and futures are very different contracts. An option on the one hand is a contract to purchase or sell the underlying asset. Whereas, a futures contract is an agreement to take or make delivery of a commodity. In an options contract the buyer pays the premium to acquire the contractual right. In the case of a call option the buyer acquires the right to purchase the futures contract. The seller who has received the premium is now obligated to deliver the futures contract at the strike price. In the case of a put option the buyer pays the premium to the seller and now has the right to sell the futures contract at the strike price. The seller of the put option because he / she received the premium is now obligated to purchase the futures contract. When 2 parties enter into a transaction in a futures contract, they do not exchange premiums. The buyer and seller of the contract must both deposit the required margin with their FCM. Therefore neither party acquires a right from the other. Instead both parties are now obligated to perform under the terms of the contract. The buyer who is now long the contract is obligated to take delivery of the commodity. While the seller who is short the contract is now obligated to to make delivery. The margin collected from both parties is their good faith deposit and it shows to the exchange and clearinghouse that they will be able to meet their obligations under the contract.