CPT Risk Management & Capital Allocation 3 — Questions and Answers
Question 1: A trader uses the Kelly Criterion and calculates a Kelly percentage of 25%. To reduce risk of ruin while still benefiting from Kelly sizing, the recommended approach is to use:
- Full Kelly (25%)
- Half Kelly (12.5%) (Correct answer)
- Double Kelly (50%)
- No fixed fraction; use intuition
Correct answer: Half Kelly (12.5%)
Half Kelly (50% of the full Kelly percentage) is widely recommended to reduce volatility and risk of ruin while preserving most of the long-term growth benefit.
Question 2: Which scenario best illustrates 'overleverage' risk for a retail trader?
- Using 2:1 leverage on a well-tested swing strategy with defined stops
- Using 50:1 leverage on a volatile forex pair with no stop-loss (Correct answer)
- Holding a position overnight with a trailing stop
- Diversifying across five uncorrelated instruments at 5:1 leverage each
Correct answer: Using 50:1 leverage on a volatile forex pair with no stop-loss
Using 50:1 leverage on a volatile pair with no stop-loss exposes the trader to catastrophic loss that can wipe out the entire account on a single adverse move.
Question 3: What is the primary purpose of a 'maximum daily loss limit' rule in a professional trading firm?
- To limit the number of trades executed per day
- To prevent a single bad day from causing irreversible account damage that compromises future trading (Correct answer)
- To comply with SEC reporting requirements for institutional traders
- To ensure the trader takes profits before the market closes
Correct answer: To prevent a single bad day from causing irreversible account damage that compromises future trading
A daily loss limit caps how much can be lost in one session, preserving enough capital and psychological stability to continue trading the next day.
Question 4: In the context of prop trading evaluations, what does 'scaling up' typically mean?
- Increasing position size proportionally as account equity grows after consistent profitability (Correct answer)
- Entering multiple trades simultaneously on correlated assets
- Reducing the number of trades while increasing hold time
- Moving from equities to derivatives to access higher leverage
Correct answer: Increasing position size proportionally as account equity grows after consistent profitability
Scaling up means the prop firm grants larger capital allocations to traders who demonstrate consistent profitability and disciplined risk management.
Question 5: A trader has a win rate of 60% and an average win of $200, but an average loss of $400. What is the expected value per trade?
- +$40
- -$40 (Correct answer)
- +$80
- -$80
Correct answer: -$40
EV = (0.60 × $200) − (0.40 × $400) = $120 − $160 = −$40; the strategy is a net loser despite the high win rate.
Question 6: Which concept describes the statistical tendency for returns to move back toward the mean after extreme performance, which traders must account for in capital allocation?
- Momentum persistence
- Mean reversion (Correct answer)
- Survivorship bias
- Volatility clustering
Correct answer: Mean reversion
Mean reversion describes the tendency for extreme gains or losses to revert toward the long-run average, making sustained outlier performance unlikely.
Question 7: What is the function of a 'trailing stop' in risk management?
- It sets a fixed loss level that never changes once entered
- It moves the stop-loss in the direction of a profitable trade to lock in gains while limiting downside (Correct answer)
- It automatically reduces position size as volatility increases
- It places additional orders at intervals below the entry to average down
Correct answer: It moves the stop-loss in the direction of a profitable trade to lock in gains while limiting downside
A trailing stop follows the price as it moves favorably, locking in profit incrementally while still allowing the trade to run further if the trend continues.
CPT Risk Management & Capital Allocation 3
A trader uses the Kelly Criterion and calculates a Kelly percentage of 25%.
To reduce risk of ruin while still benefiting from Kelly sizing, the recommended approach is to use: