31 terms

Risk & Psychology — 31 terms defined

Every risk & psychology term in the StockTools glossary, in plain language with a worked example — and connected to the free calculator that puts it to work.

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BacktestingBacktesting is running a precisely defined set of trading rules against historical data to measure how it would have performed. The output worth keeping is a trade distribution — win rate, average win and loss, expectancy, maximum drawdown — not a single equity-curve number.Risk & Psychology Bag HolderA bag holder is a trader left holding a position far below cost after the move that attracted them has died, now waiting indefinitely to "get back to even." The term is standard market vocabulary, usually applied to buyers who arrived late in a pump or a fading momentum name and never took the stop.Risk & Psychology Behavioral FinanceBehavioral finance studies how psychological biases and emotions cause investors to make decisions that deviate from purely rational, self-interested behavior, and how those deviations show up in market prices. It challenges the assumption, central to classical finance theory, that investors always act rationally.Risk & Psychology Black Swan EventA black swan event is a rare, extreme, and largely unpredictable occurrence with severe consequences, a term popularized by Nassim Nicholas Taleb, that is only widely understood as significant in hindsight. The 2008 financial crisis and the initial 2020 pandemic market crash are commonly cited examples.Risk & Psychology Confirmation BiasConfirmation bias is the tendency to seek out, favor, and remember information that confirms an existing belief while ignoring or discounting information that contradicts it. In investing, this often shows up as only reading bullish analysis on a stock you already own and dismissing bearish arguments without giving them equal weight.Risk & Psychology DrawdownDrawdown is the decline from an account's equity peak to its subsequent low, quoted as a percentage of that peak. An account that grows to $50,000 and falls to $40,000 is in a 20% drawdown even if it started at $30,000.Risk & Psychology ExpectancyExpectancy is the average amount a trading approach makes or loses per trade: expectancy = (win rate x average win) - (loss rate x average loss). A positive number means the edge is real; a negative number means more trades just lose money faster.Risk & Psychology FOMOFOMO — fear of missing out — is the urge to buy a stock because it is already running and everyone else seems to be getting paid. The entry is driven by the pain of watching, not by a setup, which is why FOMO buys cluster near short-term tops.Risk & Psychology HedgingHedging is holding an offsetting position so that a loss in one holding is partly or fully canceled by a gain in another. Common equity hedges include buying puts against long stock, shorting a correlated name or index ETF against a long book, and collaring a position with options.Risk & Psychology Kelly CriterionThe Kelly criterion is a formula for the bet size that maximizes long-run compound growth: Kelly fraction = edge / odds. In trading form, f = W - (1 - W) / R, where W is the win rate and R is the ratio of average win to average loss.Risk & Psychology LeverageLeverage is control of a position larger than the cash behind it, using borrowed money or derivatives, so that gains and losses are computed on the full position size rather than the equity. A 2:1 levered account moves twice as fast as the underlying stock, in both directions.Risk & Psychology Loss AversionLoss aversion is the well-documented tendency for the pain of losing money to feel more intense than the pleasure of gaining the same amount, a core finding of behavioral economics research by Daniel Kahneman and Amos Tversky. Studies have suggested losses can feel roughly twice as psychologically powerful as equivalent gains.Risk & Psychology Maintenance MarginMaintenance margin is the minimum equity, as a percentage of position value, that a margin account must hold after a position is opened. FINRA sets the regulatory floor at 25% for long stock; brokers typically impose stricter house requirements of 30-40%, and raise them further on volatile or hard-to-borrow names.Risk & Psychology MarginMargin is money borrowed from a broker to buy securities, with the account's holdings as collateral. Under Regulation T, the initial margin requirement is 50%: a trader must put up at least half the purchase price in cash or equity, so $10,000 of equity supports at most $20,000 of stock.Risk & Psychology Margin CallA margin call is a broker's demand for more cash or securities after account equity falls below the maintenance margin requirement. Meeting it means depositing funds or closing positions; failing to meet it means the broker liquidates positions itself, at whatever prices the market offers.Risk & Psychology OvertradingOvertrading is taking substantially more trades than a strategy actually signals — filling dead hours with C-grade setups, re-entering after stops, trading for stimulation instead of edge. It is the most common leak in day trading P&L because each extra trade adds cost while adding no expectancy.Risk & Psychology Paper TradingPaper trading is placing simulated trades with fake money against real market quotes, used to test a strategy or platform before risking capital. Every major broker offers a simulator, and it is the standard way to learn order entry without paying tuition to the market.Risk & Psychology Position SizingPosition sizing is the calculation that decides how many shares or contracts to trade so that a losing trade costs a fixed, predetermined slice of the account. The formula: shares = dollar risk per trade / (entry price - stop price). Size is an output of the stop distance, never a number picked first.Risk & Psychology R MultipleAn R multiple states a trade's outcome as a multiple of the amount risked at entry: R multiple = profit or loss / initial risk. If the planned risk (1R) was $200 and the trade made $500, the result is +2.5R; a full stop-out is -1R.Risk & Psychology Revenge TradingRevenge trading is jumping back into the market immediately after a loss to win the money back, typically with larger size and no qualifying setup. The trade is aimed at repairing the P&L and the ego, not at an edge, which is why it compounds the original damage more often than it fixes it.Risk & Psychology Risk of RuinRisk of ruin is the probability that losses drive an account down to a level it cannot recover from — either literal zero or the point where the trader can no longer size positions meaningfully. It is a function of three inputs: win rate, payoff ratio, and the fraction of equity risked per trade.Risk & Psychology Risk-Reward RatioThe risk-reward ratio compares what a trade can lose against what it can plausibly make: the distance from entry to stop versus the distance from entry to target. A trade risking $1 to make $3 has a 1:3 risk-reward ratio.Risk & Psychology Sharpe RatioThe Sharpe ratio is excess return per unit of volatility: (portfolio return - risk-free rate) / standard deviation of returns. William Sharpe introduced it in 1966, and it remains the default answer to the question every raw return dodges — how much risk did it take to get that number?Risk & PsychologySortino RatioThe Sortino ratio is the Sharpe ratio with one change: the denominator counts only downside volatility, so returns above the target do not count against the strategy. The formula is (portfolio return - risk-free rate) / downside deviation, where downside deviation penalizes only the below-target returns — above-target periods enter the calculation as zeros, not as risk.Risk & Psychology Stop LossA stop loss is a predefined exit that closes a losing position once price reaches a set level, capping the damage from a trade that did not work. Mechanically it is usually a stop order resting with the broker, which converts to a market order when the stop price trades.Risk & Psychology Sunk Cost FallacyThe sunk cost fallacy is the tendency to keep investing time or money into something because of what has already been invested, rather than evaluating the decision fresh based on its current merits. Money already spent or already lost is gone regardless of what you do next, but it still exerts a psychological pull on the next decision.Risk & Psychology Systematic Risk (Market Risk)Systematic risk is the risk inherent to the entire market or economy, like a recession, a rate hike, or a geopolitical shock, that affects nearly every asset to some degree and cannot be eliminated through diversification. It is the risk you are left with even after building a well-diversified portfolio.Risk & Psychology Take ProfitA take profit is a resting order, usually a limit order, that closes a winning position automatically at a predetermined target price. Paired with a stop loss, it brackets the trade so both exits are decided before emotions get a vote.Risk & Psychology Unsystematic Risk (Diversifiable Risk)Unsystematic risk is risk specific to a single company or industry, like a factory fire, a failed product launch, or a lawsuit, that does not affect the broader market. Unlike systematic risk, it can be substantially reduced or eliminated by holding a diversified portfolio of many unrelated positions.Risk & Psychology VolatilityVolatility is the standard deviation of an asset's returns — a statistical measure of how widely results scatter around their average, quoted as an annualized percentage. A stock with 20% annualized volatility is expected to land within 20 percentage points of its mean return in roughly two out of three years, if returns behaved normally (they do not, quite — real markets produce more extreme days than the bell curve predicts).Risk & Psychology Win RateWin rate is the percentage of trades that close at a profit — and by itself it says nothing about whether a trader makes money. A 90% win rate loses money if the rare losers are big enough, and a 30% win rate prints money if the winners run far enough.Risk & Psychology