General Securities Representative (Series 7) Practice Exam

When investors buy options to protect their positions, they are considered to be doing what?

1. Speculating

2. Hedging their position

3. Exercising their options

4. Writing a new option

The correct answer is: Hedging their position

When investors buy options to protect their positions, they are engaging in a practice known as hedging. Hedging is an investment strategy that aims to reduce or offset the risk of adverse price movements in an asset. By purchasing options, investors can lock in prices or create insurance against potential losses in their underlying investments. For example, if an investor holds shares of a stock but fears a decline in its price, they may purchase put options on that stock. If the stock's price does indeed fall, the value of the put options will increase, allowing the investor to sell the stock at a predetermined price, thereby minimizing their losses. This protective strategy is a common use of options among investors focused on risk management rather than outright speculation. In contrast, options trading can also involve speculation, exercising options, or writing new options, but these actions do not specifically focus on protecting existing positions the way hedging does. The central purpose of hedging is to create a safety net against market volatility or unfavorable moves in asset prices.