"Where are they walking?"
Translation:Wo laufen sie?
WO and Wohin should have two distinct applications. If we are talking about a direction especially when something moves (like here going somwhere) we should use Wohin not Wo.
You are right, but notice that in English, since the question is too ambiguous and it could have the two interpretations, in order to distinguish the two, a final "to" would be added: It's not the same "Where are they walking?", and " Where are they walking to?" I think this is why "Wo" is used.
the English sentence "Where are they walking?" has two possible interpretations:
Wo laufen sie? - Sie laufen im Park. Wohin laufen sie? - Sie laufen nach Hause.
Still, I think "wohin" would be the more logical choice in this case and it was counted as wrong.
The verb usually goes first in a question except, when you have one of the six w question words starting the sentence.
I don't see any difference between Wo sie laufen? and Wo laufen sie.
Although you may be right, when I took German classes, they always taught be that the verb must go in the second position in a question (correct me if I am wrong), so in this case it will be "Wo laufen sie?"