Chartered Financial Analyst (CFA) Practice Exam Level 2

When can a stop loss limit be utilized in risk management?

1. To increase the average holding period of investments

2. To liquidate a portfolio if daily losses exceed a certain threshold

3. To allow for greater risk exposure in volatile markets

4. To ensure all investments remain unchanged

The correct answer is: To liquidate a portfolio if daily losses exceed a certain threshold

Using a stop loss limit in risk management is most effectively implemented to liquidate a portfolio if daily losses exceed a certain threshold. A stop loss order is designed to limit an investor's loss on a position by automatically selling the asset when it reaches a predetermined price. This mechanism provides a safeguard against significant declines in the value of an investment, allowing the investor to manage their risk by capping potential losses. In a volatile market, employing a stop-loss limit can help prevent excessive losses by triggering a sale before the situation worsens. This strategy is particularly useful for investors who want to protect their capital while still having the ability to participate in potential market gains. The other options do not accurately reflect the purpose of a stop loss limit. Increasing the average holding period of investments is contrary to the nature of stop loss orders, which are used to exit investments under certain conditions. Similarly, allowing for greater risk exposure in volatile markets does not align with the primary intention of stop loss limits, which is to mitigate risk rather than enhance it. Lastly, ensuring all investments remain unchanged directly contradicts the function of stop loss limits, as their purpose is to initiate changes in the investment portfolio based on market movements.