General Securities Representative (Series 7) Practice Exam

What is the best way to protect using options?

1. Buy calls

2. Buy puts

3. Sell puts

4. Sell calls

The correct answer is: Buy puts

Buying puts is considered one of the best strategies for protecting an investment, especially in a declining market. When an investor buys a put option, they acquire the right to sell the underlying asset at a predetermined price (the strike price) before the option expires. This function acts as a form of insurance against a drop in the price of the underlying asset. If the value of the asset decreases, the investor can exercise the put option, effectively selling the asset at a higher price than the current market value, thereby limiting losses. Even if the investor does not exercise the option, the cost of buying the put (the premium) serves as a hedge against downside risk. This strategy allows investors to maintain their long positions in the market while having protection in place should the market turn against them. In contrast, other strategies such as buying calls, selling puts, or selling calls do not provide similar protective benefits. Buying calls is a bullish strategy, aimed at profiting from an increase in asset prices, and does not provide downside protection. Selling puts can potentially obligate the seller to buy an asset at the strike price if it's exercised, which could result in losses should the asset decline significantly. Selling calls, on the other hand, exposes the seller to unlimited risk if