This week’s study question from the Solomon Online Exam Simulator question database is now available.
Question (Relevant to the Series 7, Series 62, Series 65, Series 66, and Series 99):
Your client is short 100 XOM at $75, and wants to hedge his position. To protect him from the risk that XOM’s stock price may rise, you recommend that he:
Answers:
A. Buy a put
B. Sell a put
C. Sell a call
D. Buy a call
Correct Answer: D, Buy a call
“To hedge” means to put limits on how much you can gain or lose from an investment by taking the opposite position from your current position.
When it comes to options, an investor can hedge a position in two ways:
- Buying an option to buy protection. In this specific question, buying a call buys protection from a rise in the share price. If it were a long position, the investor could buy a put to protect against a decline in the share price.
- Selling an option to gain income. In this question, by selling an option the investor gains income, which may mitigate losses, but he also limits how much he can gain from the short sale.
If an exam question says “to hedge risk and get the best protection” go for buying an option (puts for long positions, calls for short positions)
If the exam questions says “to hedge risk and increase income” go for selling an option (calls for long positions, puts for short positions)
In this question, the investor is going for protection and is not seeking income so the best answer is to buy a call. While selling a put is a possible hedge it is not the most appropriate hedge for this investor’s goal.
Weekly study questions are from Solomon’s industry-leading Online Exam Simulator.