Stress test
How do traders check whether a position could survive an extreme week like one that already happened?
In plain words
A stress test is a calculation that applies the price moves of a past extreme week to a position as it stands today, to estimate what the loss, margin use and volatility exposure would have been under those conditions.
Why it matters
It answers a question that average-case estimates hide: not what usually happens, but what happened the last time things went badly. A position sized on normal weeks can exceed its risk limit under a replayed week, which is the gap a stress test is designed to reveal before it appears in the account.
In a real week: ETH, week of 12 July 2021
Using ETH's week of 12 July 2021 as the test week: the return was -11.63%, the range was 17.53%, realised volatility reached 80.7% a year, and the largest hourly move was 3.72%. The week closed at 14.6% of its range, in the lower third, after three of the four prior weeks were down, and volume was 0.36 times its prior 12-week average, marking a severe historical benchmark to replay against a position.
A common mistake
Treating one replayed week as the worst case. It is a historical benchmark; the next extreme week can be deeper, faster, or move in the opposite direction.