Stock Trading Risk Assessment & Management 5 — Questions and Answers
Question 1: What does a beta of 1.5 indicate about a stock's risk relative to the S&P 500?
- The stock is 50% less volatile than the market
- The stock tends to move 1.5 times the magnitude of the market (Correct answer)
- The stock has a 1.5% correlation with the market
- The stock earns 1.5% more than the risk-free rate
Correct answer: The stock tends to move 1.5 times the magnitude of the market
A beta of 1.5 means the stock historically moves approximately 150% as much as the S&P 500 — amplifying both gains and losses.
Question 2: A portfolio manager uses a 'stop-and-reverse' rule after a 15% drawdown. What is the primary purpose of this rule?
- To lock in profits before market close
- To force a pause and strategy reassessment when losses indicate something may be wrong (Correct answer)
- To trigger automatic rebalancing between asset classes
- To comply with FINRA day-trading regulations
Correct answer: To force a pause and strategy reassessment when losses indicate something may be wrong
A drawdown-based stop-and-reverse rule forces traders to step back and reassess their approach before losses compound further.
Question 3: Which of the following best describes 'counterparty risk' in stock trading?
- The risk that the opposing trader in a transaction has better information
- The risk that a broker, clearinghouse, or counterparty fails to fulfill its financial obligation (Correct answer)
- The risk that a stock's price moves against your position
- The risk of trade execution errors by your broker
Correct answer: The risk that a broker, clearinghouse, or counterparty fails to fulfill its financial obligation
Counterparty risk is the possibility that the other party in a transaction (broker, clearinghouse, or OTC dealer) defaults on its obligations.
Question 4: When is the Kelly Criterion most appropriately applied in trading?
- To determine the optimal leverage ratio for day trading futures
- To calculate the optimal position size as a fraction of capital based on win rate and win/loss ratio (Correct answer)
- To set stop-loss levels based on historical volatility
- To time market entries using probability distributions
Correct answer: To calculate the optimal position size as a fraction of capital based on win rate and win/loss ratio
The Kelly Criterion calculates the mathematically optimal percentage of capital to risk on each trade given a known edge (win rate and payoff ratio).
Question 5: A trader holds a short position in a stock that unexpectedly surges 40% in one day. Which risk does this illustrate?
- Theta risk
- Short squeeze risk with theoretically unlimited loss potential (Correct answer)
- Delta risk from options expiration
- Liquidity risk from wide bid-ask spreads
Correct answer: Short squeeze risk with theoretically unlimited loss potential
Short sellers face theoretically unlimited losses because a stock's price can rise without bound, and short squeezes can accelerate the move violently.
Question 6: What is the main advantage of using a 'trailing stop' over a fixed stop-loss order?
- It eliminates slippage on all exit orders
- It automatically locks in profits as the trade moves favorably while still limiting downside (Correct answer)
- It reduces the number of trades required, lowering commission costs
- It guarantees execution at the exact stop price
Correct answer: It automatically locks in profits as the trade moves favorably while still limiting downside
A trailing stop moves in the direction of a profitable trade, protecting gains while allowing the position to continue running if momentum persists.
Question 7: Which risk management concept does 'not putting more than 5% of your portfolio in any single stock' directly address?
- Systematic risk
- Concentration risk through position size limits (Correct answer)
- Liquidity risk through diversification
- Margin risk through leverage reduction
Correct answer: Concentration risk through position size limits
Capping individual position sizes at 5% directly limits concentration risk by ensuring no single stock can devastate the overall portfolio.
Stock Trading Risk Assessment & Management 5
What does a beta of 1.5 indicate about a stock's risk relative to the S&P 500?