Series 3 Examination

The Series 3 examination, also known as the National Commodities Futures Examination (NCFE), is required for anyone seeking membership in the National Futures Association (NFA). Some employers in the field of national commodity futures require employees to take this examination either immediately upon hire or within six months to a year.

Below is a list of the major subject areas covered in the Series 3 examination. This is a general list and should only be used as a starting point for study.

Part I: Futures trading theory and basic functions terminology

General theory

• Development of futures markets
• Futures and securities compared (rights, obligations, and transfer of ownership)

The futures contract

• Futures and forward contracts compared
• Offset provisions
• The clearinghouse function (clearing and non-clearing members)
• Delivery provisions (basis grade, premiums, and discounts)

The structure of futures markets

• Normal markets (carrying charges and “full-carry” markets)
• Inverted markets (supply shortages and other factors)

Hedging theory

• Risk reduction (unhedged position and the effect of pricing on cash markets)
• Short hedging (typical short hedgers, such as farmers, producers, and holders of inventory; and the effect of pricing on cash markets)
• Long hedging (typical long hedgers, such as processors, manufacturers, and exporters; and the protection long hedging can afford them against the rise of prices)

Speculative theory

• Leverage
• Risk
• Market liquidity
• Price volatility

General futures terminology

• Associated person
• Basis
• Bucketing
• Carrying charges
• Churning
• Clearinghouse
• Convergence
• Commodity pool operator
• Commodity trading advisor
• Deferred
• Discount
• Expit
• Futures commission merchant
• First notice day
• Floor broker
• Floor trader
• Forward contract
• Introducing broker
• Inverted market
• Limit up/down
• Lock limit
• Long
• Normal market
• Pit
• Position trader
• Retender
• Scalper
• Short
• Spot
• Variation call
• Warehouse receipt

General options terminology

• At-the-money
• Call
• Conversion
• Delta
• Exercise
• Expiration
• Grantor
• In-the-money
• Intrinsic Value
• Out-of-the-money
• Premium
• Put
• Spread
• Straddle
• Strangle
• Synthetic options/futures
• Time value
• Writer

Part II: Futures margins, options premiums, price limits, futures settlements, delivery, exercise, and assignment

Margin requirements

• The nature of futures margin (performance bond, comparison with securities margin, the authority of exchanges to establish and revise requirements, initial and maintenance requirements, and documentation as it pertains to margin agreements and transfer of funds agreements)
• Margin calculations (initial, maintenance and variation, the effects of substantial price movement, the effects of change in requirements on new and existing positions, and withdrawal of excess equity)
• Alternative calculations (hedge margin and spread margin)

Options premiums

• Intrinsic value
• Time value
• The delta
• Premium quotations

Price limits

• The effect of limit-up or limit-down price change
• Expanded limits
• The effects of limit moves on margin
• Lock limit
• Circuit breakers

Offsetting contracts, settlements, and delivery

• Liquidating long and short positions
• First notice day
• Trading in the spot month
• The clearinghouse role in the delivery
• Delivery notices
• Retenders and stopped notices
• Physical delivery and warehouse receipts
• How settlement is computed for cash settled contracts (stock indices, municipal bonds, and Eurodollars)
• EFPs

Options exercise, assignment, and settlement

• Process of assignment
• Margin requirements upon exercise
• Final trading and exercise dates

Part III: Types of orders, customer accounts, and price analysis

Basic characteristics and uses of:

• Market orders
• Stop orders
• Stop-limit orders
• Market-if-touched orders
• Orders on electronic markets

Additional orders

• Good Till Canceled (GTC)
• Fill or kill
• On close
• One Cancels the Other (OCO)

Technical price analysis

• Bar, point, and figure charts
• Trendlines
• Support and resistance levels
• Congestion areas
• Gaps
• Ascending and descending triangles
• Double tops and bottoms
• Volume and open interest
• Liquidating markets

Fundamental price analysis

• Effects of economic and political instability
• Supply and demand elasticity
• United States agricultural policies
• Crop years
• Hog to corn ratio

Interest rate analysis

• Positive, inverted, and flat yield curves
• The effects of governmental policies, particularly tax policy and monetary policy

Part IV: Basic hedging and basis calculations

Short hedging and long hedging

• Anticipatory hedges
• Long the basis/short the basis

The basis

• How the basis is determined
• The effect of basis charge on the short hedger and the long hedger
• The effect on the price of a commodity actually delivered or purchased (transportation costs and the variety of deliverable grades)
• The basis in financial markets (short term rates vs. long term rates, the “implied repo rate”)

Hedging calculations

• Net result of hedge
• Net price received upon purchase or sale

Part V: Spreading

Spread trading

• Order execution
• Expectations (narrowing or widening basis; normal or inverted market strategies)

Common types of spreads

• Carrying charge or limited risk spreads (intra-market or inter-delivery)
• Bull and bear spreads
• Intermarket spreads

Part VI: Speculating in futures

Profit and loss calculations for speculative trades

• Gross profit on speculative trades
• The effect of commissions on gross profits
• Return on (margin) equity calculations

Trading applications

• Recommend speculative trades
• Use orders to initiate and protect position

Part VII: Option hedging, speculating, and spreading

Option theory

• Long (limited risk, increased leverage, and total loss of investment possible)
• Short (increased risk, earn premium, loss may exceed premium received)

Option hedge strategies and calculations

• Long put as alternative to short futures hedge
• Long call as alternative to long futures hedge
• Allows for increased profit once break-even point is reached

Option speculative strategies and calculations

• Long call as substitute for long futures
• Long put as substitute for short futures
• Long call to protect short futures
• Long put to protect long futures
• Long futures-short call
• Conversions
• Reverse conversions

Option spread strategies and calculations

• Call bull spreads
• Call bear spreads
• Put bull spreads
• Put bear spreads
• Calendar spreads
• Arbitrage spreads

Part VIII: Regulations

• General
• CFTC registrations/NFA membership
• Futures account opening requirements
• Position reporting requirements
• Speculative position limits

FCM/IB (Futures Commission Merchant/Introducing Broker) regulations

• Guaranteed and independent IBs
• Net capital requirements
• Financial reports
• Collection of margin deposits
• Customer complaints
• Time stamping requirements
• Promotional material
• Disclosure by FCMs and IBs required for costs associated with futures transactions

CPO/CTA (Commodity Pool Operator/Commodity Trading Advisor)

• Disclosure documents
• Records to be maintained
• Promotional material

NFA (National Futures Association) disciplinary procedures

• Formal complaints
• Warning letters
• Hearings
• Member responsibility actions
• Penalties for violators

Arbitration procedures

The CFTC (Commodity Futures Trading Commission) and the enforcement of the Commodity Exchange Act (CEA)

Series 3 Examination Practice Questions

1. Which term denotes an inverse relationship between the price of a commodity and the demand for that commodity?

a. Supply elasticity
b. Supply inelasticity
c. Demand elasticity
d. Demand inelasticity

2. What type of economic policy would the federal government be undertaking if it wanted to increase the demand for credit?

a. Monetary policy
b. Federal Funds policy
c. Public policy
d. Fiscal policy

3. Which type of futures trade includes investments in bonds?

a. Stock index futures
b. Interest rate futures
c. Foreign currency futures
d. Exchange rate futures

4. Which type of yield curve indicates that short term debt has a higher yield than long term debt?

a. Reversed yield curve
b. Normal yield curve
c. Inverted yield curve
d. Flat yield curve

5. Which strategy protects investments against interest rate risk?

a. A short hedge
b. A cross hedge
c. A current investment hedge
d. An anticipatory hedge

Answers

1. C: Demand elasticity. Demand elasticity is the relationship between price and demand, which can be either elastic or inelastic. If the price of a commodity increases 8% and demand drops 20%, the relationship between price and demand is elastic. If the price of a commodity increases 10% and demand remains the same, the relationship between price and demand is inelastic. Supply elasticity refers to the availability of a particular commodity in the marketplace. The supply of a commodity can increase or decrease in accordance with the number of producers of that commodity. If the number of producers is severely limited, and it is difficult for new players to enter the market, the supply is inelastic. If supply inventories drop, and it is easy for new producers to come into the marketplace and produce additional supply, then there is supply elasticity.

2. D: Fiscal policy. Fiscal policy is the umbrella of government spending policies that affect tax and interest rates and government spending. When government borrows, its debt increases. Government borrowing can result in an increase in the demand for credit as well as in higher interest rates. Higher interest rates caused by expansionary government policies put downward pressure on bond prices and make them less desirable for investors. Monetary policy refers to the actions of a central bank. In the United States, monetary policy is set by the Federal Reserve Board, and involves actions specifically designed to control the growth of the money supply and the availability of credit.

3. B: Interest rate futures. Interest rate futures are based on financial and debt instruments which benefit from interest rates. They may include treasury bills, bonds, or Certificates of Deposit (CD). Stock index futures are a diversified portfolio of stocks grouped by sector. A stock or commodities index is the underlying asset used in the purchase of stock index futures; therefore the stock index futures reflect the activity of a broader spectrum of the market. A particular index may include more than 1,000 individual stocks or contain less than 100. Foreign currency futures are based on the particular currencies of the countries chosen for investment. Most currency futures trading are conducted in the currencies of more politically and fiscally stable countries.

4. C: Inverted yield curve. A normal yield curve, considered positive, reflects a condition in which the short-term yield is less than the yield from long-term debt. A graph of a normal yield curve would be reflected in a gradually ascending line, indicating that bonds, or other debt purchased and held for long term maturity, have an overall higher yield than short term debt. An inverted yield curve shows economic conditions where short-term debt has a higher yield than long-term debt, with yield declining as debt progresses to the maturity date. The downward sloping line on the graph indicates a declining revenue stream, and the inversion of the normal yield to maturity relationship.

5. A: A short hedge. There are two ways for an investor to hedge against interest rate risk. A short hedge protects against the cost of borrowing by locking in a current interest rate in anticipation of future borrowing at higher interest rates. In a long hedge, the investor hedges a current investment in debt securities by purchasing a futures contract with the expectation of lower rates and cheaper borrowing. Cross hedging takes an offsetting position in a different but price-related commodity. In a current investment hedge, an investor holding bonds would short futures to hedge against the risks of current investment. An anticipatory hedge guards against changes in interest rates and bond yields with the investor buying a futures contract to lock in an attractive yield in a debt instrument. Anticipatory hedges are long hedges.