General Securities Representative (Series 7) Practice Exam

What is the purpose of hedging in options trading?

1. To increase profit from price movements

2. To eliminate all risk

3. To minimize losses from adverse price movements

4. To maximize trading frequency

The correct answer is: To minimize losses from adverse price movements

Hedging in options trading primarily serves the purpose of minimizing losses from adverse price movements. Investors use hedging strategies to protect their positions against the risk of unfavorable market conditions. By utilizing options, traders can effectively offset potential losses in their underlying asset positions. For example, if an investor owns shares of a stock and is concerned about a potential decline in the stock's price, they might purchase put options. These put options give them the right to sell the shares at a predetermined price, thus offering a safety net against significant losses. While the strategy may involve some costs, such as the premium paid for the options, the primary goal is to provide a layer of protection rather than to completely eliminate risk or to increase profit from price movements. Hedging does not guarantee profits and cannot eliminate risk entirely; it merely seeks to reduce the impact of adverse price shifts. Thus, the correct answer reflects the primary objective of hedging in options trading.