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Stress testing

Revaluing a portfolio under deliberately severe conditions to find out what breaks, rather than estimating what is statistically likely.

Stress testing abandons probability. You do not ask how likely a 20% two-day index drop is; you apply it and read the damage, then check whether the resulting equity still meets margin, still allows you to trade, and still leaves you willing to trade.

A workable retail version takes ten minutes. Apply to every open position: minus 20% on the index with betas applied, correlations forced to 0.9, volatility doubled, and bid-ask spreads tripled on exit. Then ask three questions - what is the loss, does it breach maintenance-margin, and can the positions actually be exited at those spreads? Options books should add a separate volatility shock, since a long-premium book can gain in the same scenario that ruins a short-premium one.

The output is a decision, not a report. If the stressed result is unsurvivable, the fix is smaller size or defined risk today, while the market is calm and the choice is still yours.

Related: scenario-analysis, worst-case-loss, correlation-breakdown, forced-liquidation

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Margin and leverageA small deposit controlling a much larger position, and the point at which losses trigger a margin call.Position you controlnotional value $100,000your margin deposit: $5,000$100,000 / $5,000 = 20:1 leverageYour deposit absorbs every dollar of loss$5,000$2,500$0Equity leftMARGIN CALLequity has fallen to $2,5000%1%2%2.5%3%4%5%How far the price moves against you
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.

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