Stock Trading Case Studies & Practical Application 3 — Questions and Answers
Question 1: A swing trader buys a stock at $80 and sets a price target of $100 with a stop-loss at $72. What is the reward-to-risk ratio?
- 1:1
- 2:1
- 2.5:1 (Correct answer)
- 1.5:1
Correct answer: 2.5:1
Reward = $100 - $80 = $20; risk = $80 - $72 = $8; ratio = $20 / $8 = 2.5:1.
Question 2: An investor holds a highly concentrated position in a single tech stock that has tripled. Which strategy reduces concentration risk while deferring immediate tax liability?
- Selling all shares immediately
- Using an exchange fund or protective collar (Correct answer)
- Buying more shares to lower cost basis
- Converting shares to bonds
Correct answer: Using an exchange fund or protective collar
An exchange fund allows diversification by pooling concentrated positions, while a collar uses options to limit downside without triggering immediate taxes.
Question 3: A company announces a 2-for-1 stock split. An investor who held 150 shares at $200 each now holds:
- 75 shares at $400
- 300 shares at $100 (Correct answer)
- 150 shares at $100
- 300 shares at $200
Correct answer: 300 shares at $100
A 2-for-1 split doubles shares and halves price: 150 × 2 = 300 shares at $200 / 2 = $100 each.
Question 4: During the dot-com bubble, many traders ignored P/E ratios for tech stocks. Which behavioral bias best explains this?
- Anchoring bias
- Disposition effect
- Recency bias driving 'new paradigm' thinking (Correct answer)
- Loss aversion
Correct answer: Recency bias driving 'new paradigm' thinking
Recency bias led investors to believe recent rapid growth would continue indefinitely, justifying extreme valuations with a 'new paradigm' narrative.
Question 5: A trader enters a long position when MACD crosses above the signal line and exits when RSI exceeds 70. This is an example of:
- Fundamental analysis
- A rules-based technical trading system (Correct answer)
- Insider trading
- Passive index investing
Correct answer: A rules-based technical trading system
Using defined technical indicator crossovers for entry and exit signals defines a rules-based or systematic technical trading approach.
Question 6: In 2010, the 'Flash Crash' saw the Dow drop nearly 1,000 points in minutes before recovering. The primary cause was identified as:
- A Federal Reserve rate hike
- A large sell order triggering algorithmic feedback loops (Correct answer)
- A major bank failure
- A foreign currency devaluation
Correct answer: A large sell order triggering algorithmic feedback loops
A large futures sell order triggered high-frequency trading algorithms to withdraw liquidity, creating a rapid self-reinforcing price collapse.
Question 7: A value investor finds a stock trading at a P/E of 8 with strong free cash flow, while the sector average P/E is 20. This is an example of seeking a:
- Momentum trade
- Margin of safety (Correct answer)
- Short squeeze setup
- Pair trade
Correct answer: Margin of safety
Benjamin Graham's 'margin of safety' principle involves buying assets significantly below intrinsic value to protect against errors and downside risk.
Stock Trading Case Studies & Practical Application 3
A swing trader buys a stock at $80 and sets a price target of $100 with a stop-loss at $72.
What is the reward-to-risk ratio?