Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

STRESS TESTING

Stress testing attempts to address many of the flaws inherent in VaR exercises. Value at risk tries to quantify the likelihood of our portfolio's breaching of a particular loss threshold over a specified time horizon, but says nothing regarding the degree of severity of a particular loss. Stress testing attempts to quantify how bad the unlikely event could get, but—for the most part—fails to examine the probability of the particular event's occurrence. As such, stress tests are ideal complements to VaR analyses.

A comprehensive examination of stress testing methodologies is beyond the scope of this text.⁷ However, an example will explain the basic concept and its utility. One of the simplest and most popular types of stress tests is known as scenario analysis. In scenario analysis, we apply to our current portfolio holdings either a hypothetical scenario, such as a 100 basis point rise in interest rates, or an actual historical scenario, such as the stock market crash of 1987, to determine our portfolio's vulnerability. Once our stress test has identified such portfolio hot spots, we can reduce these exposures by reducing position exposures or purchasing options.

Of course, stress testing has its own weaknesses, including the fact that neither hypothetical nor historical scenarios has any significant chance of resembling actual future price shock events (and therefore our protective risk management measures might prove quite ineffectual). Nevertheless, because stress ...