General Securities Representative (Series 7) Practice Exam

How do investors typically use option positions to hedge their stock positions?

1. By avoiding market trades

2. Buying options to protect their stock

3. Only writing options

4. Taking on more risk

The correct answer is: Buying options to protect their stock

Investors frequently buy options to create a protective strategy for their existing stock positions, which is often referred to as "hedging." By purchasing put options, for example, investors gain the right to sell their shares at a predetermined price within a specified period. This action can effectively mitigate potential losses in the value of their stock holdings. If the stock price declines, the profit from the put option can offset some or all of the losses incurred on the stock itself, thereby providing a safety net. In contrast, avoiding market trades does not provide any impactful protection. Only writing options could lead to increased risk rather than a hedging mechanism, as it exposes the investor to potential unfavorable market movements. Lastly, taking on more risk is the opposite of hedging; the goal of hedging is to reduce exposure to risk rather than increase it. Therefore, the approach of buying options serves as a practical and strategic measure for investors looking to safeguard their stock investments.