Risk Management & Capital Allocation Flashcards

A trader's strategy generates an average monthly return of 4% with a standard deviation of 8%. What is the approximate annualized Sharpe Ratio assuming a risk-free rate of 0%?

Answer: 1.73

Monthly Sharpe = 4/8 = 0.5; annualized Sharpe = 0.5 × √12 ≈ 0.5 × 3.464 ≈ 1.73.

What is 'slippage' and how does it affect risk management calculations?

Answer: The difference between a trader's planned entry and the actual fill price, which can widen realized losses beyond the planned stop-loss

Slippage is the gap between the expected price and the actual execution price, which means real losses can exceed the planned risk amount, especially in fast-moving or illiquid markets.

In prop trading evaluation contexts, what is the typical consequence of breaching the 'maximum loss limit' (often called the 'account blow' threshold)?

Answer: The account is disabled and the evaluation or funded account is terminated immediately

Breaching the maximum loss threshold on a prop firm account results in immediate termination of the challenge or funded account, with the trader needing to repurchase access.

Which capital allocation principle states that a trader should never risk more money than they are mentally and emotionally prepared to lose entirely?

Answer: The 'scared money' principle

The 'scared money' principle holds that trading with capital you cannot emotionally afford to lose causes fear-driven decision-making, leading to premature exits and poor execution.

A trader notices that after a series of wins, they begin increasing position sizes beyond their rules. This behavior is known as what, and why is it dangerous?

Answer: Overconfidence bias; it is dangerous because it leads to oversized losses when the inevitable losing streak arrives

Overconfidence bias following a winning streak causes traders to abandon their rules and take excessive risk, making the inevitable drawdown far more severe than it needed to be.

What is 'risk of ruin' in the context of trading, and which factor most rapidly increases it?

Answer: The probability of account depletion; it increases fastest when the risk-per-trade percentage is increased

Risk of ruin is the probability of losing all or a defined percentage of capital; even a small increase in the percentage risked per trade dramatically increases this probability due to compounding effects.

A trader is offered a funded account of $200,000 with a 5% maximum drawdown rule ($10,000 max loss) and an 8% profit target ($16,000). They use a fixed 0.5% risk per trade. Approximately how many losing trades in a row would breach the drawdown limit?

Answer: 10

0.5% of $200,000 = $1,000 risk per trade; $10,000 / $1,000 = 10 consecutive losing trades to hit the drawdown limit.