Question

An investor wants to profit from a speculative, near-future market advance, but he is uncertain which stocks will be affected. To limit his risk to a specific amount, which of the following actions would best meet his objectives?

A) Sell puts on a narrow-based stock index.
B) Buy calls on a narrow-based stock index.
C) Purchase several blue-chip stocks on margin.
D) Buy calls on a broad-based stock index.

Answer 1

To limit risk while aiming to profit from a market increase, the investor should buy calls on a broad-based stock index, which offers potential gains with risk limited to the premium paid for the calls. This approach benefits from market diversification similar to index funds.

Step-by-step explanation:

The investor wants to profit from a speculative, near-future market advance while limiting risk. The action that best meets his objectives is D) Buy calls on a broad-based stock index. This strategy allows the investor to profit from the rise of the entire market without betting on individual stocks. Buying calls provides the right, but not the obligation, to buy the index at a set price before a specified date. If the market advances, the calls could significantly increase in value, offering the potential for profit. The risk is limited to the premium paid for the calls.

Investing in index funds is a form of diversification because they mimic the performance of the market as a whole, decreasing the risk associated with any single firm. Mutual funds can span from very narrow to broad holdings, with some owning a small portion of every firm in the stock market. Therefore, a call option on a broad-based stock index is akin to betting on the average performance of the market, rather than on individual stocks.