Something a little different for today’s blog; a video about how to answer questions. Click the link below to view it.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

In July 2012, the new FINRA Suitability Rule 2111 became the standard for all broker-dealers to adhere to. Suitability is a large component of the Series 7 Examination and may also be covered on the Series 6, 10, 24, and 26 Examinations. With this in mind, let’s review FINRA Rule 2111. The rule is divided into parts A (retail investors) and B (institutional investors). We will discuss Part A only as it relates to your regulatory examination.

The rule states: “A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to,

  1. The customer’s age
  2. Other investments
  3. Financial situation and needs
  4. Tax status
  5. Investment objectives
  6. Investment experience
  7. Investment time horizon
  8. Liquidity needs
  9. Risk tolerance
  10. Any other information the customer may disclose to the member or associated person in connection with such recommendation”


Clearly, the Rule 2111 list is long and specific. However, since FINRA acknowledges that some firms currently ask customers for this information without using these specific terms, the rule does not dictate the use of specific terminology or a method for obtaining this information.


If a firm decides to exclude any of these factors as irrelevant, it needs to explain in writing why it is not requesting the information. (Age, for example, would not be relevant for clients that are entities.)


FINRA confirms that nothing in the rule changes the long-standing practice that suitability becomes an issue as soon as the firm or one of its associated personnel makes a recommendation.

FINRA spells out several guiding principles for determining whether a communication is a recommendation.

  • Content, context, and presentation are important—e.g., would it be reasonably viewed as a suggestion to take or not take action?
  • The more individually tailored a communication is, the more likely it will be classified as a recommendation.
  • Although a series of actions that, considered individually, may not be considered a recommendation, may collectively be viewed as one.
  • A recommendation does not need to come from a live person—it may be computer-generated.

FINRA also notes that a recommendation is not suitable just because the client agreed to act upon it, and that a firm (and its personnel) may not avoid liability for unsuitable investments by using disclaimers.

Rule 2011 identifies three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. Each one must be addressed with regard to recommendations to clients.

Reasonable-Basis Suitability: Is it appropriate for anyone?  According to FINRA, “Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.”

In general, the amount of diligence that a firm or its associated personnel is required to undertake will vary depending on the complexity and potential risks of the investment product or strategy, and how familiar the firm or its personnel are with the product or strategy. The firm and its personnel must understand the potential risks and rewards associated with recommendations made to clients.

Customer-Specific Suitability: Is it appropriate for that client? FINRA states “Customer-specific suitability requires that a broker have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. …. The new rule requires a broker to attempt to obtain and analyze a broad array of customer-specific factors.”

Quantitative Suitability:  Are you trading too much? The third and final obligation under the new suitability rules addresses discretion. It is called quantitative suitability and requires a registered representative “who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.”

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a number of questions covering the various aspects of suitability.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Following FINRA’s change to the Series 7 Content Outline in late 2011, leveraged and inverse exchange-traded funds (ETFs) became a topic that is a potential test item students may see on their exam. You can read more about ETFs in our Study Manual, but let’s visit them briefly here.

Wall Street has a long tradition of financial innovation, and with every new product created there is always a new set of risk factors to consider, reactions to evaluate, and problems to solve. Some relatively recent innovations in the ETF industry are leveraged ETFs that produce a fund leveraged 2 or 3 times to its underlying index, and inverse ETFs that move in the opposite direction of an index, and inverse, leveraged ETFs. These nontraditional ETFs make suitability determination more critical for the investment professional.

FINRA wants registered representatives and investors alike to understand that while these vehicles potentially amplify returns, they also amplify risk. Here is how this happens. While the traditional ETFs are designed to track the value of an index on a one-for-one basis, leveraged ETFs are designed to amplify those movements 2 or 3 times. Rather than gaining leverage by buying securities on margin, investors can buy leveraged ETFs in a cash account that does not permit margin purchases, and receive the benefits of leverage without obtaining approval for a margin account. In essence, investors are exposing themselves to some, but not all, of the risks of leverage through margin. Although leverage can amplify gains, it can also amplify losses. The use of leverage through a leveraged ETF may not be suitable for many investors who cannot bear the risk. Because IRAs, self-directed 401(k) plans, and other retirement accounts are designed as nonleveraged investment arrangements, the use of leveraged ETFs in these accounts is problematic.

ETFs with an inverse investment orientation are designed to rise in value when the underlying index falls. They are used by investors with contrarian investment strategies. Investors who anticipate a decline in an index can buy an inverse ETF instead of selling short a traditional one. Conversely, if the index rises in value, an inverse ETF will fall.

Inverse ETFs give investors more flexibility in their investment strategies. For example, an investor who has an account that does not permit short selling, such as an IRA or a self-directed 401(k) plan, can participate in bearish investment strategies or can hedge a long portfolio by buying inverse ETFs. Leveraged versions of inverse ETFs are also available. This raises the question as to whether these investments are suitable in retirement, education savings, or other tax-deferred accounts that prohibit short selling.

One of the items that is crucial for a registered representative to understand and be able to communicate is the effect of market movements on an investor’s portfolio. For example, suppose an investor purchases $20,000 worth of an inverse S&P 500 ETF. If the market drops 10% on day one, but rises 5% the next day, what will the value of their investment be? The math is important to understand. First, the market drop is exactly what the investor wanted, and since the ETF is inverse, it will increase in value by the amount of the decline. So, the $20,000 investment will on day one gain 10%, or $2,000. Now it has a market value of $22,000. However the next day the market goes up 5%, which means that the ETF will lose 5% or $1,100. ($22,000 x 5% (.05) = $1,100). So the ending value of the investor’s position on day two would be $20,900. Again, understanding how to calculate these numbers is very important.

According to FINRA, because leveraged ETFs are rebalanced daily, they are not suitable for holding periods of longer than one day, unless they are used as part of a sophisticated trading strategy that is monitored by a financial professional. This is because daily leveraged compounding can cause these investments to behave differently than traditional ETFs in the long term. Daily leveraged compounding of losses can result in returns that are significantly lower than expected. It may also result in losses that are much higher, particularly in volatile markets.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about leveraged and inverse exchange-traded funds (ETFs).

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Is there anything more adrenaline-rushing than debating accounting statements among friends?  Boring as it might be for some, this material is tested on many of the regulatory examinations, so you will at least need to learn the basics.

There are three accounting statements—the income statement, balance sheet, and statement of cash flows. The income statement and balance sheet are probably the most analyzed, i.e., the ones most likely to be on your regulatory examination. This summary is a primer for those who have never dealt with either one.

The most straightforward of the three financial reports is the income statement. Simply stated, it takes a company’s revenues and subtracts its expenses to arrive at the firm’s net income—a measure of the firm’s profits or losses over a given period, typically a year.

The first expenses to appear on an income statement are related to the production of the goods or services the company offers. They are operating expenses. The cost of inventory (cost of goods sold) [COGS] represents the amount the firm’s inventory costs to produce. The COGS for the most part includes materials and labor. Selling, general, and administrative expenses (SG&A) represents compensation to sales staff, attorneys, administrative staff, and executives.

Research and development (R&D), you may have guessed, is used to pay researchers and developers. The depreciation and amortization figure (D&A) is one of the more difficult concepts on the income statement. It is the process that accountants use to allocate the cost of equipment.

For example, if UPS buys a delivery truck, they lay out the money this year. However, the truck will provide several years of benefits to the firm. Instead of taking the full purchase price against income in the year the truck is bought, the company will apply some of the value against sales in the next several years. The value taken every year comes under the heading of depreciation and amortization* expense. After all of the aforementioned expenses are applied, you are left with operating income.

*Depreciation applies to tangible assets, such as equipment. Amortization applies to intangible assets, such as patents or trademarks.

Operating income is also referred to as earnings before interest and taxes (EBIT). The next step is to deduct interest. This is an important consideration, since bond interest is deducted before taxes. Firms often prefer to issue bonds over stock where dividends are deducted from net income. There’s a whole academic discussion about issuing bonds versus stock and how taxes affect that decision. After interest is deducted, taxes are paid, leaving the firm with Net Income (the bottom line).

Technically, since other deductions will be made, it is not really the bottom line. Preferred dividends are paid, leaving the firm with earnings available to common shares, which is used in the earnings per share (EPS) calculation. At this point, there’s nothing else left to subtract and the firm is left with retained earnings. Retained earnings are then added to the company’s balance sheet, which is the link between the income statement and the balance sheet.

The balance sheet measures the net worth of a company. It takes what a company owns (i.e., assets) and subtracts what it owes its creditors (i.e., liabilities), leaving net worth, also called shareholders’ equity. The balance sheet gets its name from the balance sheet equation that requires that if you change one component you must also change another component. In other words, all transactions must offset one another—i.e., balance. The balance sheet equation is Equity = Assets – Liabilities, or Assets = Liabilities + Equity.

The asset section of the balance sheet represents what a company possesses to generate revenue—machinery, office space, land, trucks, cash, inventory, and patents. Current assets are items that can be used in one year or less. Cash and inventory are two of the larger items in current assets. Another example is accounts receivables, which is what the firm’s clients owe. For example, if I bought lunch at McDonald’s today using a credit card, my bill would be part of McDonald’s accounts receivables.

Fixed assets have a useful life exceeding one year. Property, plant, and equipment (PP&E) are a big part of fixed assets. Land is also a fixed asset. However, land is different since its value is not depreciated, whereas most other fixed assets are written down every year.

The final section of the assets section is intangibles, which is where the accounting gets less scientific and more theoretical. Intangibles include patents, trademarks, and other intellectual property.** Goodwill is usually listed separately from all the other intangibles. It represents the amount over the asset value a firm pays to acquire another firm.

For example, if Company A bought Company B for $2 million, but B’s assets were worth only $1.5 million on the balance sheet, then $500,000 of goodwill is created. In theory, accountants will tell you that goodwill measures brand loyalty, reputation in an industry, or just a warm and fuzzy feeling about a company. In practice, goodwill is an accountant’s statement that a firm is worth more than the sum of its parts. Goodwill is difficult to measure accurately. In any event, it will be reevaluated and adjusted annually.

**Remember, intangibles are amortized, not depreciated.   

Liabilities are obligations that a firm must meet or, more simply, money it owes to others. The balance sheet divides liabilities into two categories. Liabilities that are due this year are current liabilities. Those due beyond this year are long-term. Accounts, dividends, and taxes payable are typical current liabilities. Certain types of leases, promissory notes, and bonds especially are long-term liabilities. Liquidity measurements, such as working capital and the current ratio, compare current assets and current liabilities. The leverage measurements compare interest-related liabilities with cash flows, income, total capitalization*** or even equity. Most analyses regarding liabilities are concerned with making sure they don’t get too large.

***Total Capitalization = Debt + Equity

The equity part of the balance sheet is the most intimidating for beginners. As discussed earlier, shareholders’ equity represents the residual value of a firm (i.e., net worth) after liabilities are paid (i.e., Equity = Assets – Liabilities). If the assets are not large enough to cover the liabilities, the firm will have negative equity. This sometimes occurs in the real world, especially for firms that are going through bankruptcy.

An often misunderstood portion of the equity section is the value of common shares. It is misleading because the figure includes only their par value. Par value of a common share might represent what it costs to create or print the certificate. Accountants don’t put much thought into the par value, usually giving it a nominal value such as $1.00 or $0.01. We must account for more than par value though, since shareholders usually will pay more than par to buy a share at issuance.

For example, if a company issues stock for $40 and par is $1, only $1 goes into common shares. The other $39 goes into paid-in capital, also called capital surplus. Paid-in capital is usually much larger than par value. Other parts of the equity section include noncontrolling interest, which comes up in mergers or acquisitions, and preferred equity, which accounts for the preferred shareholders. Neither one of these is all that relevant to an introductory discussion, so we’ll skip the details.

The largest part of the equity section is typically retained earnings. The retained earnings figure is the historical sum of all the company’s earnings not paid to shareholders. In theory, all of a company’s profits could be redistributed to the shareholders. When a firm pays dividends, the retained earnings figure decreases, since dividends are paid from retained earnings. Reporting a profit on the income statement increases retained earnings. Since not all of the profits are paid to the shareholders, what is not paid goes into retained earnings.

Jumping into the accounting statements can be daunting if you have never studied accounting. While this post is only an introduction to the balance sheet and income statement, your regulatory examinations will go further. The current ratio, quick ratio, working capital, earnings per share, price-earnings ratio, and others metrics, are all based on either the income statement, balance sheet, or both. If you get the basics down, the calculations will follow.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded funds (ETFs) became a topic that is a potential test item students may see on their exam. You can read more about ETFs in our Study Manual, but let’s visit them briefly here.

Exchange-traded funds are investment companies, either open-end or unit investment trusts, that differ from mutual funds in the way they are issued, traded, and redeemed. Investors can buy ETFs that track essentially every sector of the equities markets, as well as ones for fixed-income securities, commodities, currencies, metals, and hedge funds. Most recently, ETFs have been created that are leveraged 2 or 3 times to an index, as well as ones that are leveraged to the inverse of an index. We will discuss leveraged and inverse ETFs and the concerns they raise in a separate blog. For now, we will focus on traditional ones and the ways they differ from mutual funds.

One disadvantage of a mutual fund is that there is no secondary market for its shares. Shares can be redeemed only by the mutual fund company. Since shares must be redeemed at the fund’s closing net asset value (forward pricing), the investor does not know the full redemption value of the shares until the market closes for that day.

The inconvenience of forward pricing may be apparent especially in circumstances where an investor is engaging in a same-day substitution, selling a mutual fund with the intention of using the proceeds for the purchase of another securities product. If the full redemption price of the mutual fund is not known, it is difficult to invest in another product simultaneously with the sale of the fund. This problem is most critical in a tax-deferred account where the customer may have limited funds to invest without making additional contributions.

ETFs do not have forward pricing. They trade in the secondary market and can be purchased or sold anytime throughout the trading day. Therefore, the liquidation value is known immediately and the investor can reinvest the proceeds without delay. It is easy to move in and out of most ETF positions. However, this ease of purchasing and selling ETF shares can cause inexperienced individuals to make inappropriate trading decisions. They may find themselves entering and exiting a position more frequently than necessary, generating excessive commissions that outweigh any gains they may have realized.

There are management fees and administrative costs associated with both mutual funds and ETFs. These fees and costs increase the expense ratios of both. Active management results in higher management fees and administrative costs. Actively managed mutual funds have the highest expense ratios. Passively managed index mutual funds have expense ratios that are lower than actively managed funds because management fees and administrative costs are lower.

Since mutual funds are purchased and redeemed directly from the issuer, they may not be sold short. Selling short and rapidly covering is attractive to the short-term trader, and also to a money manager who wants to take short positions in overvalued sectors to hedge long bets made on stocks. Since ETFs may be sold short, they have an advantage over mutual funds.

Mutual funds may not be purchased on margin. ETFs may, and, in the hands of experienced investors, can enhance returns. If the wrong investment decisions are made, however, margin can amplify losses and have a negative impact on an investor’s portfolio. Consequently, the use of margin may be suitable for some investors but not for others.

An actively managed fund will produce capital gains as its managers buy and sell stocks, which the fund must pass on to its shareholders once each year. This means that investors may incur capital gains taxes even if the net asset value of the mutual fund has actually declined in value or remained the same.

As with index funds, ETFs tend to minimize capital gains taxes since their turnover is usually low. ETFs can be redeemed the same way, minimizing the purchase and sale of securities within the fund. Traditional ETFs will remove securities and replace them only when the underlying index changes and the fund must rebalance its holdings.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETFs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Recently, U.S. equity markets updated their market-wide circuit breakers rule. For those unfamiliar with circuit breakers, they are used to protect investors from a huge decline in overall stock prices.

STC has written a summary of the updated rules.

The changes in the circuit breaker rules, which are designed to address extraordinary volatility across securities markets, include (1) replacing the DJIA with the S&P 500® Index as the reference index, (2) recalculating the values of the triggers on a daily basis rather than quarterly, (3) reducing the market decline trigger percentages, (4) shortening the length of the trading halts associated with each market decline level, and (5) modifying the times when a trading halt may be triggered.

 Trigger Value Time Action (all times Eastern Time)

 Level 1: 7% decline between 9:30 a.m. and 3:25 p.m.—15 minute trading halt

Level 2: 13% decline between 9:30 a.m. and 3:25 p.m.—15 minute trading halt

Level 3: 20% decline anytime trading halts for the remainder of the day

 At or after 3:25 p.m., trading will continue unless there is a Level 3 halt.

The Dow Jones Industrial Average (DJIA) was used as the benchmark for the old circuit breaker rule. It’s actually one of the oldest financial benchmarks in the world, created at the end of the Nineteenth Century. It was named after the persons who created it, Charles Dow and Edward Jones. Their intent was to create an overview of U.S. stock prices. There was actually a transportation index created before the industrial index, creatively called the Dow Jones Transportation Index.

The industrial index was composed primarily of industrial companies. Dow and Jones may have been financial pioneers, but they lacked pizazz when naming things. Anyway, the index originally had companies dealing with rubber, coal, electricity, and natural gas (i.e., industrials). The index is now comprised of industrial juggernauts such as Disney, Microsoft, and Bank of America, which aren’t really industrial companies so the name really doesn’t fit anymore. Nowadays, the Dow Jones Industrial Average is really 30 of the best companies in the U.S., regardless of the industry they’re in.

The most important aspect of the DJIA is how the value is calculated. It is price-weighted. To determine the value, the prices of all 30 companies are added and the result is then divided by the number of companies in the index.* The denominator, also known as the Dow Divisor, started off as the number of companies in the index, which created the average** that most people are familiar with. Over the years, the Dow Divisor needed to be updated for spinoffs, stock splits, and stock dividends. We’ll skip the adjustment calculation, but today the divisor is about 0.13, which means the index value is greater than the sum of the prices of the stocks. It doesn’t look much like a typical average.

The other issue with the Dow (and really any price-weighted index) is that it doesn’t reflect changes in total value or market capitalization of the index. Let’s simplify things a bit and say the DJIA only has two stocks. Company A is relatively small, has only100 shares outstanding, and a market value of $100. Company B has 1,000,000 shares outstanding and a market value of $10. Company A has a market cap of $10,000 (100 shares x $100) and Company B’s market cap is $10 million (1 million shares x $10). Economically speaking, Company B is contributing much more to the total value of the U.S. stock market. However, changes in Company A’s price will have a larger effect on the index because one of its shares is worth 10 times as much as Company B’s ($100 compared to $10). In short, price-weighted indexes (e.g., DJIA) make no adjustment for the total value of a company. They simply consider the value of a single share.

*Formula form:

(Σ (Stock Price))/(Number of Companies in the Index)


(Σ (Stock Price))/(Dow Divisor)

**It’s officially an arithmetic average in case the math police are reading this.

The flaw in a price-weighting index became a bigger issue as U.S. equity markets became more valuable. Industry analysts began using a new index valuation method—market-value indexing. Market value (capitalization-weighted) indexes use a weighted average to calculate the index’s value. To derive the value of a market-weighted index, add the number of shares outstanding multiplied by the market price of the shares for each company in the index and divide by the total number of shares for each company in the index.***  I’ll admit that’s a bit of a simplification. In reality, the denominator, the number of shares, will need to be adjusted for spinoffs, stock splits, and stock dividends, much like the Dow Divisor. By taking a weighted approach, price-weighted indexes tend to more accurately represent the total value of the shares in the index. Small companies no longer have a large effect on the value of the index, unlike the DJIA.

***Formula form:

(Σ (Price x Quantity))/(Σ Number of Shares)


(Σ (Price x Quantity))/Divisor

There are quite a few market-weighted indexes. In fact, the Dow is somewhat unique as a price-weighted index. The circuit breaker rules now use the S&P 500, which tracks some of the 500 largest market cap stocks in the U.S. The specific companies that make up the index are chosen by a committee. The methodology can be read about here. While the S&P is a broader index than the Dow, its goal is the same—to provide a summary of the U.S. stock market. The S&P 500 Index is also calculated a bit differently than described in the previous paragraph. Instead of using the total number of shares issued, the S&P uses only the number of shares freely available (public float), which is known as float-adjusted weighting. In finance, creativity is never wasted on naming things. The difference is sometimes significant, but won’t really change the basic understanding of market value indexing.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded notes (ETNs) became a topic that is a potential test item students may see on their exam. You can read more about ETNs in our Study Manual, but let’s visit them briefly here.

Essentially, an ETN is an unsecured debt obligation that may be worth much more at maturity than its purchase price depending on the performance of the assets or index to which it is linked. The dealer adjusts the intraday and closing indicative values based on the performance of the linked index. The market price often closely tracks that value, although there may be variations based on supply and demand. Unlike an exchange-traded fund (ETF) that is subject only to market risk, ETNs are subject to both market risk and credit risk. The price of an ETN will also reflect the credit quality of its issuer. As a result, an investor must review the liquidity of any given ETN as well.

Although ETNs must be registered under the Securities Act of 1933, they are not classified as investment companies. They are structured products that contain a debt obligation of the issuer that is linked to an index that represents a basket of stocks, bonds, commodities, interest rates, volatility, master limited partnerships, private equity, or metals. Derivative contracts are employed to provide the linked returns. An investor’s return is based on the performance of the underlying index, and ETNs are not principal-protected. If returns on the index are meager or nonexistent and fees outweigh appreciation, it is possible for the investor to experience a negative rate of return.

As with ETFs, ETNs can be leveraged or nonleveraged, inverse and noninverse. Those that are nonleveraged mirror the performance of the linked index. Those that are leveraged can return two or three times the return of the linked index. The values of inverse ETNs and inverse leveraged ETNs move in the opposite direction of the linked index. Similar to leveraged and inverse leveraged ETFs, leveraged ETNs are rebalanced daily or monthly and are best suited for short-term trading and not buy-and-hold strategies. They are not suitable for long-term investors because the daily or monthly rebalancing of leverage could result in the leveraged compounding of losses.

ETNs can experience large price swings when issuers increase or decrease the creation of notes. For example, if an issuer stops creating a popular ETN, demand may outstrip supply, causing prices to rise. When the issuer begins creating notes again, supply will increase, causing the ETN’s price to decline.  Investors who bought the ETN at its elevated price may experience a loss if they need to liquidate their holdings at the subsequent depressed prices.

Unlike ETFs, ETNs can be called at the discretion of the issuer. If an issuer finds that a particular issue or group of issues lacks investor interest, the issuer might call the ETN. Investors receive the ETN’s indicative value, based on the performance of the linked index less fees. This may result in a gain or a loss depending on the ETN’s purchase price.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETNs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

As an instructor, there are some concepts that are more difficult to explain than others. Because time is limited, advanced concepts that aren’t heavily tested are compressed. In Series 3, contango and backwardation markets are a good example. Today, we’ll attempt to give contango a more robust explanation than we would in class.

Contango doesn’t even sound like English, and it’s never been entirely clear to me whether it’s a noun or a verb. Contango is actually a mispronunciation of the word continuation. Simply stated, a market is in contango when the forward or futures price is higher than the spot (cash) price. In a contango market, the further you continue along the forward curve, the higher the prices are.

A market in backwardation has a higher cash price, with futures going progressively lower. Since most of the time markets are in contango, the term backwardation, which is the opposite of contango, comes from the idea that the market is abnormal or backward. So far so good, and if you’re just looking for answers to questions on your exam, this is the extent of what will be asked. But we promised a robust explanation, so let’s continue.

As we’ve said, a market is in contango when futures prices are higher than spot prices. So, what causes it? The futures premium is usually caused by the costs of holding onto the commodity. This is known as the cost of carry. For example, if I own 20,000 bushels of wheat, I’ll need to put it somewhere. It’s not going to fit into my apartment, so I’ll have to pay storage costs plus insurance and financing (i.e., carrying charges). What if I bought a futures or forward contract instead? Well, I wouldn’t have to worry about storing anything until delivery, which is typically preferable.

Predictably, the convenience of owning futures over the spot (cash) commodities causes futures prices to rise above the spot price and, before you know it, you have a contango market. The further into the future you look, the higher futures prices will be. The comparison of near and far delivery futures contracts is known as the forward curve. In a contango market, the forward curve is positive (i.e., upward sloping).

If a market is in contango, what will happen to prices in a few months? As students of commodities know, the spot (cash) price and the futures (forward) price must be the same upon the arrival of the delivery month. If they’re not, traders can arbitrage the difference, which will drive the prices closer anyway. In a contango market, either futures prices must fall or cash prices must rise as the delivery month approaches. So, which is it?

Historically, the futures prices will fall to meet the spot price as the delivery month approaches. This has been a problem for investors that bought commodity ETFs, which are typically long futures, not the spot commodity. As delivery nears, futures prices fall and the ETFs lose money, even if the underlying cash price isn’t moving at all. Most ETFs have the option to choose whether they buy futures or the cash commodity, which makes it difficult for retail investors to know the risks of an ETF portfolio at any given time.

Profits can be made in a contango market by those holding the cash commodity. Assuming we had a spare oil tanker lying around, we could buy spot crude oil and sell futures. As the delilvery month approaches, we will profit on our futures position as the futures price falls, and we deliver the oil in the tanker. In some instances, there has been more oil in tankers just sitting around in a contango trade, than actually being sent somewhere. This type of contango trade will be profitable, as long as the futures premium keeps exceeding the cost of carry.

If contango is normal, then what causes the market to be abnormal? The short answer is a shortage of the cash commodity or a spike in demand. Under these conditions, the futures price will be lower than the spot price, which is called backwardation. In fact, the longer delilvery contracts will have lower prices than the near-month contracts. This means that the forward curve is negative (i.e., downward sloping).

Just as in a contango market, futures prices and cash prices must meet at the time of delivery. In backwardation, futures prices tend to rise to meet the cash price as the delivery month approaches, which is similar to how futures prices fall as the delivery month approaches in a contango market. This means that long futures positions will tend to profit and short positions will tend to lose. This can be especially problematic for producers of a commodity such as farmers, who sell futures to hedge. Profits can be made in backwardation by buying long-dated futures and then selling in the cash market at delivery. Some traders will also buy long-dated futures and sell near-dated futures, which is called a calendar spread.

Thanks for spending time with us. We hope you found it worthwhile.

-Securities Training Corporation


Tricky Question Episode 1

There are always some practice exam questions that students bring to our attention. These questions are generally confusing to them, even after reading the explanation. In this and upcoming posts, we’ll try to shed light on the more difficult exam questions we’ve written. If you have suggestions for future questions, let us know. Today we’re discussing a favorite from our Series 7 Course.

An investor who wishes to hedge a portfolio of preferred stocks would buy which TWO of the following options?

I.            Yield-based option calls

II.            Yield-based option puts

III.            Interest-rate option calls

IV.            Interest-rate option puts

A. I and III
B. I and IV
C. II and III
D. II and IV

The person who came up with Roman numeral questions deserves a spot in the test-writing hall of fame. This type of question is a very effective way to test your full understanding of a concept within the confines of a single question. Many students, however, dislike them with a passion.

The best way to approach them is to ignore the choices (a), (b), (c), and (d) at first and to focus on the Roman numerals (I), (II), (III), and (IV). Think about which numerals you feel may be correct and which ones may be incorrect. From there, you can usually eliminate choices and make a better decision or, in some cases, a better guess. For example, if you know that (I) is correct in the above question, you can eliminate choices (c) and (d), since neither choice includes (I).

As you analyze the stem of the question, you see that it states that an investor wishes to hedge preferred stock. This question requires that you know how preferred stock is priced—specifically, that its price is derived mostly from interest rates, just as with bonds. In general, preferred stock and bonds are much more alike than preferred and common stock. Preferred and bonds both pay fixed income. Both have a higher priority in the event of liquidation, and both prices move in the opposite direction of interest rates.

Remember, if interest rates are rising, preferred (or bond) prices are declining and vice versa. If an investor owns preferred stock (or bonds), she is concerned that the price of her shares will decline and interest rates will rise. To summarize, this investor needs to protect against (1) preferred stock/bond prices declining and (2) interest rates rising.

There are two types of options that will help protect the investor. The complicated part in answering the question is knowing that interest-rate options are price-based and yield options are yield-based. They’re sort of opposites of one another. Interest-rate options are really just bond options.* If you buy an interest-rate call, upon exercise you’re buying a Treasury bond. This is exactly how a stock option works. So, if you think the price of Treasury bonds will rise, buying an interest-rate call is a profitable strategy. This is why they’re called price-based options. In the question, though, we’re trying to profit (hedge against) when the price is falling, so we need to buy an interest-rate put option.** Now we’re closing in. Buying interest-rate puts is choice (IV), thereby eliminating choices (a) and (c).

*Which is why the term interest-rate options is a misleading name. They should’ve named them bond options.

**Buying options is typically the best hedge. Shorting options, while fun, is not a good hedge since the trader loses control if the option is exercised.

What about numerals (I) and (II), the yield-based options? Yield-based options are based on the yield. As a reminder, bond yields move in the same direction as interest rates. Investors who think yields or interest rates will rise should buy yield-based calls. This is why yield-based options are based on interest rates and yields.

How does an investor exercise these options? In theory, someone who buys a yield-based call, and then exercises it, would buy the yield. But, you can’t really do that. Those yields don’t exist tangibly like a bond exists. They’re just numbers.*** These options have some existential issues.

To work around the small issue of yields not existing, the exchanges have made them cash-settled. Cash-settled options are a lot like gambling. The buyer of a yield-based call, instead of buying anything, will simply receive money from the seller if yields rise. The amount he gets is simply the difference in the actual yield and the strike yield (i.e., the in-the-money amount).

Cash settlement has been a Pandora’s Box for financial markets, leading to things like this. Back to the question at hand, we need to hedge against interest rates (or yields) rising. So, the best option would be buying a yield-based call—numerals (I) and (IV) are correct, which is choice B. One down, 249 questions left to answer correctly for the regulatory examination.

*** I realize Treasury bonds are book-entry securities and aren’t really tangible either. In any event, the bond is much easier to buy conceptually than the yield is.

Thanks for reading; we hope you found it worthwhile.

-Securities Training Corporation

What is the purpose of a practice exam and how should you use it?

Practice exams are designed to help you understand concepts that are tested on the real thing. Many of these exams have a reputation for being challenging and often poorly worded. Your goal should be to walk into the real exam understanding concepts so well that no matter how a question is worded, you can answer it simply because you understand the concept behind the question. When you first begin taking practice exams, they should:

  1. Prepare you to apply the knowledge you learned reading the study materials
  2. Highlight the areas you have read but do not understand
  3. Improve your ability to focus on relevant parts of a question and discard any details designed to distract you from the right answer.

So what is the key to success with taking the practice exams?

The best recommendation is to take a practice exam in a quiet setting from beginning to end; preferably with no breaks or distractions. Recreate the real exam experience as much as you can. Once you complete the exam and receive your score review the diagnostic breakdowns that we provide with each exam. We show you where your weak areas are in that particular exam.

The next step is to study those week areas in your study manual or in the class notes that you would have from a class that you may have taken already. The most important aspect of this is to make sure you don’t just jump to a brand new exam and try again. If you don’t study your weak areas in between tests you won’t improve your knowledge of a concept and you will continue to perform poorly. As mentioned in a previous blog, avoid retaking the same exam over and over again and believing the increasing scores reflect actual knowledge. In reality, it only demonstrates the fact that a person has memorized this particular exam.

Periodically we talk to people who have taken 5 or 6 exams and are consistently failing them. These people are frustrated and worried that they may fail the real exam since “I just don’t seem to be getting it.” The first question we always ask is about their exam taking habits. Consistently we will hear that they have been reading the explanations to the questions, but nothing else. This means they don’t really understand what areas they aren’t doing well in. They may think they have an understanding, however, their consistent failures prove otherwise. The lesson here is simple. Study in between each exam, based on the diagnostics in our tests. You should see your scores in those weak areas improve with each exam. If after doing this for 2-3 exams you don’t seem to be getting any better, you should call us at our Instructor Hotline for some more support and guidance. That number is 1-800-STC-EXAM.

Thanks for reading; we hope you found it worthwhile.

-Securities Training Corporation