Stock Trading Risk Assessment & Management 3 — Questions and Answers
Question 1: What is 'slippage' and how does it relate to risk management?
- The cost of borrowing shares for short selling
- The difference between expected and actual execution price, increasing effective risk (Correct answer)
- A penalty fee for exceeding margin limits
- The overnight financing charge on leveraged positions
Correct answer: The difference between expected and actual execution price, increasing effective risk
Slippage is the gap between the intended trade price and actual fill price, which increases real-world losses beyond planned stop levels.
Question 2: Which scenario best illustrates 'concentration risk'?
- Holding 30 stocks equally weighted across 10 sectors
- Having 60% of a portfolio in a single technology stock (Correct answer)
- Using leverage to amplify returns on a diversified portfolio
- Placing all trades during the market open hour
Correct answer: Having 60% of a portfolio in a single technology stock
Concentration risk occurs when a large portion of capital is allocated to a single holding, magnifying losses if that position moves adversely.
Question 3: A stock's historical volatility (HV) is 40% and its implied volatility (IV) is 25%. What does this suggest about options pricing?
- Options are relatively expensive compared to recent realized volatility
- Options are relatively cheap compared to recent realized volatility (Correct answer)
- The stock is more likely to decline than rise
- The stock has above-average liquidity
Correct answer: Options are relatively cheap compared to recent realized volatility
When IV is below HV, options are priced for less movement than recently realized, suggesting they may be underpriced.
Question 4: What is the purpose of a 'circuit breaker' in U.S. stock markets?
- To limit the maximum daily gain of individual stocks
- To halt trading temporarily during extreme market declines to prevent panic selling (Correct answer)
- To restrict short selling during market downturns
- To cap leverage ratios during volatile periods
Correct answer: To halt trading temporarily during extreme market declines to prevent panic selling
Market-wide circuit breakers pause trading when the S&P 500 falls 7%, 13%, or 20% to allow investors time to assess information.
Question 5: How does 'time decay' (theta) represent a risk for long options holders?
- Long options lose value each day as expiration approaches, even if the underlying is unchanged (Correct answer)
- Long options gain value over time due to compounding
- Time decay only affects call options, not puts
- Time decay increases the intrinsic value of in-the-money options
Correct answer: Long options lose value each day as expiration approaches, even if the underlying is unchanged
Theta erodes an option's extrinsic value daily, meaning long options holders lose money from the passage of time alone.
Question 6: Which risk management approach involves setting a maximum loss for the entire trading day before stopping all activity?
- Position sizing
- Daily drawdown limit (Correct answer)
- Portfolio rebalancing
- Hedging
Correct answer: Daily drawdown limit
A daily drawdown limit is a predefined maximum loss threshold that, when hit, requires the trader to stop trading for the day.
Question 7: A trader buys a put option to protect a long stock position. This strategy is known as:
- Covered call
- Married put (Correct answer)
- Bull spread
- Iron condor
Correct answer: Married put
A married put involves buying a put option on a stock you already own, providing downside protection like insurance.
Stock Trading Risk Assessment & Management 3
What is 'slippage' and how does it relate to risk management?