Stock Trading Research & Evidence-Based Practice 5 — Questions and Answers
Question 1: The 'disposition effect' in behavioral finance research describes investors' tendency to:
- Hold losing positions too long and sell winning positions too early (Correct answer)
- Sell losing positions quickly and hold winning positions indefinitely
- Buy at market open and sell at market close
- Concentrate all capital in a single high-conviction trade
Correct answer: Hold losing positions too long and sell winning positions too early
The disposition effect is the empirically documented bias where investors hold losers to avoid realizing a loss while selling winners prematurely to lock in gains.
Question 2: When a research paper states a strategy has a Calmar ratio of 2.5, this means:
- The strategy returned 2.5% annually
- The annualized return is 2.5 times the maximum drawdown (Correct answer)
- The strategy beat the market by 2.5 percentage points
- The standard deviation of returns is 2.5%
Correct answer: The annualized return is 2.5 times the maximum drawdown
The Calmar ratio divides annualized return by maximum drawdown; a ratio of 2.5 means the strategy earned 2.5 dollars of return for every dollar of peak-to-trough loss.
Question 3: What is the primary limitation of using only backtested results when evaluating a quantitative trading strategy?
- Backtesting software is too expensive for individual traders
- Historical conditions may not repeat, and backtest results cannot guarantee future performance (Correct answer)
- Backtesting is only valid for options strategies
- Regulators prohibit publishing backtested returns
Correct answer: Historical conditions may not repeat, and backtest results cannot guarantee future performance
Backtests are inherently backward-looking; market regimes, liquidity, and correlations change, so past performance patterns may not persist in the future.
Question 4: Which concept explains why widely-known market anomalies often disappear after academic publication?
- The arbitrage principle — informed traders exploit and eliminate the mispricing (Correct answer)
- Regulatory intervention banning the strategy
- Increased trading commissions making the anomaly unprofitable
- The SEC mandating equal access to strategy research
Correct answer: The arbitrage principle — informed traders exploit and eliminate the mispricing
Once an anomaly is published, arbitrageurs flood in to exploit it, increasing competition until the excess returns are eliminated and the anomaly disappears.
Question 5: A researcher applies a rolling 12-month analysis to evaluate a strategy. What advantage does this approach offer over a single fixed period?
- It eliminates transaction costs from the analysis
- It assesses performance across many different market environments, reducing period-specific bias (Correct answer)
- It guarantees the strategy will work in any market condition
- It automatically adjusts position sizing based on volatility
Correct answer: It assesses performance across many different market environments, reducing period-specific bias
Rolling analysis examines performance across overlapping windows, capturing a variety of market regimes and reducing the risk of conclusions being skewed by a uniquely favorable or unfavorable period.
Question 6: Which SEC filing is the most comprehensive primary source for evaluating a company's financial health and risks?
- Form 8-K
- Form 10-K (Correct answer)
- Form 4
- Form S-1
Correct answer: Form 10-K
The Form 10-K is the annual report filed with the SEC containing audited financial statements, management discussion, and detailed risk factors.
Question 7: What is 'regime change' risk in the context of evidence-based trading research?
- Political instability causing stock market crashes
- A shift in underlying market conditions that renders a previously valid strategy ineffective (Correct answer)
- A change in SEC regulations affecting short selling
- A company's CEO being replaced, altering its growth trajectory
Correct answer: A shift in underlying market conditions that renders a previously valid strategy ineffective
Regime change risk refers to structural shifts in market dynamics — such as changes in volatility, correlations, or liquidity — that can invalidate strategies built on prior data.
Stock Trading Research & Evidence-Based Practice 5
The 'disposition effect' in behavioral finance research describes investors' tendency to: