Advanced Diploma of Financial Planning (ADFP) Practice Test

What advantage does a short position provide an investor?

1. It allows profits from an increase in a security's value

2. It benefits from a decline in the value of a security

3. It secures dividends from the stock

4. It protects against total loss of investment

The correct answer is: It benefits from a decline in the value of a security

A short position allows an investor to benefit from a decline in the value of a security. This investment strategy involves borrowing shares of a security and selling them with the anticipation that their price will drop. If the price falls as expected, the investor can repurchase the shares at the lower price, return them to the lender, and pocket the difference as profit. This mechanism is the essence of short selling; thus, the primary advantage lies in the potential to make money when the market moves against the position held by the original owner of the shares. In contrast, other options reflect scenarios that do not align with the nature of short selling. For instance, profiting from an increase in a security's value contradicts the premise of a short position, which relies entirely on the value declining. Securing dividends does not pertain to short selling, as short sellers do not own the stocks they have shorted, hence they are not entitled to any dividends. Lastly, while a short position can limit certain losses compared to outright ownership, it does not protect against total loss as the potential for loss is theoretically unlimited if the stock price rises significantly. Thus, the identified advantage situates short selling firmly as a strategy designed to capitalize on falling prices.