Series 7 Exam Question 124: Answer and Explanation

Question: 124

All of the following are reasons an investor might sell a security short EXCEPT:

• A. for hedging purposes
• B. to take advantage of an arbitrage situation
• C. to have the potential for a maximum gain on the security that is unlimited
• D. for speculation

Correct Answer: C

Explanation:

C. Investors may sell a security short (borrow securities for immediate resale) for hedging purposes, speculation, or arbitrage situations. When an investor is hedging, they can sell short securities they already own to protect from a loss in the event the market declines. When selling short for speculation, the investor believes the price of the underlying security will decline so they can later repurchase the stock at a lower price. Selling short for arbitrage purposes means the security is selling at different prices on different markets. In this case, the investor would sell short the security on the market where the price is high and purchase the security on the market where the price is low. There is no unlimited maximum gain potential when selling a security short because the price of the security can only go to zero, but there is a maximum loss potential that is unlimited.