Risk Management & Trading Strategies Flashcards

What is the main goal of risk management in trading?

Answer: Minimize losses and protect capital

The main goal of risk management in trading is to minimize potential losses and protect trading capital. This involves implementing strategies and rules to control exposure to risk, ensuring that no single trade or series of trades can severely deplete the trading account. Effective risk management is crucial for long-term survival and profitability in the markets.

What does a stop-loss order do?

Answer: Sells shares to limit losses

A stop-loss order is an instruction to sell an asset once its price falls to a specified level. Its primary purpose is to limit a trader's potential loss on a position. By automatically executing a sale at a predetermined price, it helps prevent further capital erosion if the market moves unfavorably.

Which strategy involves diversifying investments?

Answer: Diversification

Diversification is an investment strategy that involves spreading investments across various assets, industries, and geographic regions. The goal is to reduce overall portfolio risk by ensuring that a poor performance in one investment does not severely impact the entire portfolio. This strategy helps mitigate unsystematic risk.

What defines a risk/reward ratio?

Answer: Comparison of potential reward to risk

A risk/reward ratio is a crucial metric that compares the potential profit of a trade to its potential loss. It helps traders assess the attractiveness of a trade by quantifying how much they stand to gain versus how much they risk. A favorable ratio, such as 2:1 or 3:1, indicates that the potential reward is significantly greater than the potential risk.

Which trading strategy profits from falling prices?

Answer: Short selling

Short selling is a trading strategy where an investor borrows shares and sells them, hoping to buy them back later at a lower price. The profit is made from the difference between the selling price and the repurchase price. This strategy allows traders to profit from falling market prices.

What is a trailing stop order?

Answer: Dynamic stop that moves with price

A trailing stop order is a dynamic stop-loss order that automatically adjusts its price as the market price of an asset moves favorably. It maintains a specified distance (either a percentage or a fixed amount) below the market price for a long position, or above for a short position. This allows traders to lock in profits while still giving the trade room to run, and it automatically limits losses if the price reverses.

What is position sizing in trading?

Answer: Determining trade size based on risk

Position sizing is the process of determining the appropriate number of shares or contracts to trade for a given investment. It is a critical component of risk management, as it ensures that the amount of capital risked on any single trade aligns with the trader's overall risk tolerance and account size. Proper position sizing helps protect capital from significant losses.

What is the purpose of a trading plan?

Answer: Provide structure and rules for trading

The purpose of a trading plan is to provide a clear, structured set of rules and guidelines for all trading activities. It outlines entry and exit strategies, risk management parameters, and psychological considerations, helping traders make objective decisions and avoid emotional biases. A well-defined trading plan is essential for consistency and discipline in trading.

What type of risk is associated with unexpected global events?

Answer: Systematic risk

Systematic risk, also known as market risk, is the risk inherent to the entire market or market segment. It is caused by external factors such as economic downturns, political instability, or unexpected global events, which affect all investments to some degree. This type of risk cannot be eliminated through diversification.