General Securities Representative (Series 7) Practice Exam

What is the primary purpose of buy stop orders in a short stock position?

1. Limit potential gains

2. Protect against loss and lock in gain

3. Encourage short selling

4. Facilitate margin calls

The correct answer is: Protect against loss and lock in gain

In a short stock position, a buy stop order is primarily used to protect against losses and lock in gains. When an investor sells a stock short, they are betting that the stock's price will decrease, allowing them to buy it back at a lower price for a profit. However, if the price begins to rise, the potential for losses increases. A buy stop order is placed above the current market price and is activated when the price reaches that point. This mechanism helps the investor to buy back the stock at a predetermined level, effectively limiting potential losses from an adverse price movement. Additionally, if the stock price has risen significantly, activating the buy stop can help in securing some profits even if the investor had initially anticipated that the price would fall. This strategy helps manage risk, providing a safety net by enabling the investor to exit the position before losses accumulate further. It does not affect potential gains directly in the same way as it might limit future profits if the price were to fall again after the stop order is triggered. Instead, its main purpose is ensuring that the investor does not incur significant losses if the market moves against their position.