Series 7 Exam Question 252: Answer and Explanation

Question: 252

An investor has shorted XYZ common stock at 55. XYZ common stock has recently dropped to 30, and the investor expects that the price will continue to decrease over the long term. If the investor would like to hedge against a possible increase in the price, the investor should

• A. buy an XYZ call
• B. sell an XYZ call
• C. buy an XYZ put
• D. buy an XYZ combination

Correct Answer: A

Explanation:

A. To hedge means to protect. If the investor would like to hedge his position, they should buy a call on XYZ. Remember that the investor is short the stock and must buy XYZ back at some point to close their short position. Buying an XYZ call gives the investor the right to buy back XYZ at a fixed price, which would allow the investor to protect the position and not face an unlimited maximum loss potential.