General Securities Representative (Series 7) Practice Exam

What function do sell stop orders serve in a long stock position?

1. Increase stock price

2. Protect against loss and lock in gain

3. Limit the potential losses to zero

4. Encourage buying pressure

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

Sell stop orders play a vital role for investors holding a long position in stocks, primarily serving as a risk management tool. When an investor places a sell stop order, they set a specific price point at which the order will become active. This price is typically set below the current market price of the stock. If the stock’s price falls to this predetermined level, the sell stop order triggers, executing a market order to sell the stock at the next available price. The key function of these orders is to protect against losses. By using a sell stop order, investors can establish a safety net that limits their potential losses in the event of a stock price decline, while also enabling them to lock in gains if the stock has appreciated since their purchase. This is crucial for managing risk, especially in volatile markets where prices can change rapidly. In contrast, the other options do not accurately represent the function of sell stop orders. These orders do not inherently aim to increase stock prices, eliminate all potential losses, or encourage buying pressure. Instead, they are specifically designed to provide downside protection for long stock positions, enabling investors to maintain a more disciplined investment strategy.