Stock Trading Risk Assessment & Management 4 — Questions and Answers
Question 1: What is 'systematic risk' and which tool best measures a stock's exposure to it?
- Company-specific risk; measured by standard deviation
- Market-wide risk that cannot be diversified away; measured by beta (Correct answer)
- Liquidity risk in thin markets; measured by bid-ask spread
- Regulatory risk from policy changes; measured by sector allocation
Correct answer: Market-wide risk that cannot be diversified away; measured by beta
Systematic risk affects the entire market and cannot be eliminated through diversification; beta measures how much a stock moves relative to the market.
Question 2: A trader's account falls from $100,000 to $70,000. What percentage gain is required to recover to break-even?
- 30%
- 33%
- 43% (Correct answer)
- 70%
Correct answer: 43%
A 30% loss leaves $70,000, and to recover $30,000 on a $70,000 base requires a 42.86% gain, approximately 43%.
Question 3: Which of the following best describes 'model risk' in algorithmic trading?
- The risk that trading algorithms will be copied by competitors
- The risk that a trading model performs poorly in live markets due to faulty assumptions or overfitting (Correct answer)
- The risk of server downtime disrupting automated trades
- The risk of regulatory changes banning algorithmic strategies
Correct answer: The risk that a trading model performs poorly in live markets due to faulty assumptions or overfitting
Model risk is the danger that a trading algorithm, built on historical data or flawed assumptions, fails to perform as expected in live markets.
Question 4: Under FINRA Pattern Day Trader (PDT) rules, what minimum equity must be maintained to day trade freely in a margin account?
- $10,000
- $25,000 (Correct answer)
- $50,000
- $100,000
Correct answer: $25,000
FINRA requires pattern day traders to maintain at least $25,000 in their margin accounts on any day they trade.
Question 5: What is 'gap risk' in stock trading?
- The risk from the bid-ask spread widening during low volume
- The risk that a stock opens significantly higher or lower than the previous close, bypassing stop orders (Correct answer)
- The risk from holding positions through earnings announcements
- The risk of a broker's platform going offline overnight
Correct answer: The risk that a stock opens significantly higher or lower than the previous close, bypassing stop orders
Gap risk occurs when news after market close causes a stock to open far from the prior close, making stop-loss orders fill at much worse prices.
Question 6: How does increasing position size after a series of losses (known as 'revenge trading') violate sound risk management principles?
- It reduces portfolio beta at an inopportune time
- It increases exposure when account equity is reduced, amplifying the drawdown risk (Correct answer)
- It triggers PDT restrictions by increasing trade frequency
- It violates the wash sale rule
Correct answer: It increases exposure when account equity is reduced, amplifying the drawdown risk
Revenge trading increases risk exactly when the account is weakest, compounding losses rather than preserving capital for recovery.
Question 7: Which scenario represents 'liquidity risk' for a stock trader?
- A stock's price falls 5% due to weak earnings
- Unable to exit a large position quickly without significantly moving the stock's price (Correct answer)
- A broker temporarily suspending margin trading
- A stock hitting its 52-week low
Correct answer: Unable to exit a large position quickly without significantly moving the stock's price
Liquidity risk is the inability to exit a position at a desired price because there are insufficient buyers, forcing large price concessions.
Stock Trading Risk Assessment & Management 4
What is 'systematic risk' and which tool best measures a stock's exposure to it?