Stock Trading Case Studies & Practical Application 4 — Questions and Answers
Question 1: A trader's system wins 40% of trades but has an average win of $300 and average loss of $100. Is this system profitable?
- No, because it loses more often than it wins
- Yes, because the expected value is positive (Correct answer)
- No, because a 40% win rate is too low
- Yes, but only if the trader uses maximum leverage
Correct answer: Yes, because the expected value is positive
Expected value = (0.40 × $300) + (0.60 × -$100) = $120 - $60 = +$60 per trade, making it profitable.
Question 2: Berkshire Hathaway bought a large stake in Apple starting in 2016. Which of Warren Buffett's core investing principles does this reflect?
- Speculating on short-term price movements
- Investing in businesses with durable competitive advantages (moats) (Correct answer)
- Diversifying into hundreds of small positions
- Timing the market based on macroeconomic cycles
Correct answer: Investing in businesses with durable competitive advantages (moats)
Buffett favors companies with strong brand loyalty and ecosystem lock-in — Apple's moat — held for the long term.
Question 3: A trader uses a covered call strategy by writing a call on shares they already own. What is the primary trade-off?
- Eliminates all downside risk
- Generates income but caps upside potential (Correct answer)
- Provides unlimited upside with no risk
- Reduces the cost basis below zero
Correct answer: Generates income but caps upside potential
Selling a covered call generates premium income but obligates the seller to sell shares at the strike price, capping gains above that level.
Question 4: After a major acquisition announcement, Company A's stock falls 5% while the target company's stock rises 25%. A merger arbitrage trader would:
- Short both companies
- Buy the target and short the acquirer (Correct answer)
- Buy both companies
- Short the target and buy the acquirer
Correct answer: Buy the target and short the acquirer
Merger arbitrage captures the spread by buying the (cheaper) target and shorting the acquirer to profit if the deal closes at the announced terms.
Question 5: A portfolio manager notices that small-cap value stocks historically outperform large-cap growth stocks over 10-year periods. This is an example of a market:
- Random walk
- Anomaly or factor premium (Correct answer)
- Insider trading pattern
- Algorithmic arbitrage
Correct answer: Anomaly or factor premium
The size and value premiums are documented market anomalies (factors) showing persistent excess returns that challenge pure efficient market theory.
Question 6: A company's stock is halted pending a news announcement. When trading resumes, it opens 30% higher. A retail trader who placed a market buy order during the halt will likely:
- Get filled at the pre-halt price
- Get filled at the opening price after the halt (Correct answer)
- Have their order cancelled automatically
- Receive shares at a 5% discount
Correct answer: Get filled at the opening price after the halt
Market orders execute at the prevailing price when the market reopens, meaning the trader pays the new post-halt price, not the pre-halt price.
Question 7: In technical analysis, a 'head and shoulders' top pattern signals:
- A continuation of the uptrend
- A potential trend reversal from bullish to bearish (Correct answer)
- Increasing buying volume ahead
- A support level being established
Correct answer: A potential trend reversal from bullish to bearish
The head and shoulders top is a classic reversal pattern where price fails to make new highs, signaling the uptrend may be ending.
Stock Trading Case Studies & Practical Application 4
A trader's system wins 40% of trades but has an average win of $300 and average loss of $100.
Is this system profitable?