The owner of a large, diversified stock portfolio could hedge against a steep decline in prices by

Question

Quizplus · Accepted Answer

The best choice for hedging against a steep decline in prices is to buy put options on a stock index. This would give the owner the right to sell the stocks in the portfolio at a predetermined price, providing some protection against losses. Options give the owner the right but not the obligation to buy (call) or sell (put) a specified asset at a specified price within a specified time period. Buying call options would not be as effective in hedging against a decline in prices, as the owner would benefit only if the prices rise. Selling put options would expose the owner to potentially unlimited losses if the prices decline sharply. Buying both call and put options with the same expiration date, known as a straddle strategy, could be a viable alternative, but it would be more expensive and could be less effective if the underlying stocks do not move as anticipated.

The Owner of a Large, Diversified Stock Portfolio Could Hedge