We are, by now, quite used to the idea that traders are often stressed – indeed managing this kind of emotion is a key part to any successful strategy. But you may also have heard mention of stressed markets, even stressed prices, and wondered what on earth the other person was talking about. Fortunately, these concepts are in fact very simple, although their impacts on prices are anything but: you need to be well-prepared for market stress, and it is never too early to start planning your portfolio so it can better negotiate these rapids in the changing flow of markets.
Market stress
Normally markets function continually (when open) with buyers and sellers finding each other by whatever method and executing trades at an agreed price. Today, in the vast majority of cases, this matching process takes place electronically with orders broken up into blocks that are then executed immediately with counterparties offering to buy blocks of a certain size at a certain price. This system has come to dominate internationally, with only a few holdouts lasting past the first years of the twenty-first century, most notably the London Metal Exchange which still uses a modified form of open-outcry ring trading.
This is the normal functioning of markets: market stress is simply a time when the function is threatened. For example, if a huge number of market participants are each seeking to sell $50,000 of Asset X at $100, but there is only open interest to buy $100,000 at that price, the sellers will have to accept a lower price in order to complete the transaction. This can result in sudden downwards price movements as counterparties offer lower and lower prices to complete the trades; prudent investors will sometimes try and wait out these conditions but if an asset is extremely overvalued then they may have no option but to take any price.
A closely related phenomenon is the idea of the fire sale – a forced sale of assets, either because of a lack of funding, legal or regulatory requirements, volatility, or some other reason that requires the total liquidation of an asset at any price. In fire sales, sudden declines in the price of an asset often cannot be avoided, as the market struggles to find enough open interest to fill the order. For genuinely worthless assets, the ability to trade may end as open interest dries up completely: this occurred with certain Collateralised Debt Obligations (CDO) during the 2007-2008 financial crisis. This is a classic example of market stress – the normal functioning of the market collapsed as a huge portion of participants struggled to sell assets no-one wanted.
What to do during market stress episodes
Market stress can appear suddenly and without warning, and in fact this is the normal situation when talking about bubbles bursting. In a financial bubble, with Bitcoin now normally (but controversially) used as the textbook example over tulips, an asset sees a dramatic price spike but then at the first appearance of selling pressure collapses back down to a much lower level. There are two periods of market stress and volatility here; one is when the asset’s price soars and buyers struggle to keep up with price increases, and another on the way down when it becomes increasingly difficult to find a buyer for the asset at any price.
The first and most obvious piece of advice is to avoid buying assets that are, or may be, in a bubble. This is trickier than it sounds; some analysts would claim the outperformance of various tech stocks from 2010 – 2021 was a bubble, with valuations soaring far in excess of earnings multiples, but at the same time these remained hugely valuable companies and could never be considered a worthless asset in the way that tulips were.
Market stress in the foreign exchange market
In the forex market, market stress is certainly rarer than for equities and some commodities, where bubbles and supply shortages can swiftly ramp up prices. Commodities in particular are notorious for sudden spikes, even in fully financialised markets such as oil, as physical delivery and varying levels of supply cause frequent stress events.
That said, the same principles are all at work here, with the same unfortunate effects. In times of market stress, normal correlations collapse and assets tend to move in lockstep in the same direction; down. For the forex market, the market reaction will likely depend on whether the crisis is focused on the USA or elsewhere; but even in the latter case, dollar strength is normally the result as all other currencies are considered more risky than the world’s reserve currency.
It is an interesting hypothetical to consider whether a sufficiently severe crisis could break the dollar’s status and see a flight to safety towards other currencies, but for now the pattern is strong, with the dollar the safe-haven asset of choice for forex investors.
Risk management during market stress
Market stress will strongly influence your choice of appropriate risk management techniques. Measuring and understanding risk is in many ways simply the art of predicting and managing market stress – hence the ‘stress test’ and its status as the gold standard for portfolio managers looking to examine their exposure and its performance during different scenarios.
There are two main kinds of stress test: one models the expected response to a specific market scenario, such as the fed suddenly raising rates by 1% with no warning. Another is the historical stress simulator, where a portfolio with the same rough proportion of assets to your own is tested on real historical market data from a financial crisis, such as 1987, 2001, or 2008. This can be a useful method for seeing how well a portfolio performs during times of market stress.
Historical scenarios
There are two methods of historical stress testing, one where you live trade through a historical price environment, and another where you see how a fixed portfolio would perform during the same scenario, with the second much easier to do but perhaps less useful. Using a historical scenario to model asset performance has several benefits:
- Unlike imagined stress test scenarios, historical scenarios have the enormous advantage of being real; no assumptions go into making them, just real price data.
- Even difficult to model price relationships are clear in historical data.
- Immensely detailed scenarios can be produced just using publicly available information.
The main disadvantage of historical scenarios compared to imagined ones is that you may know what happens already – for this reason 2008 is typically avoided for live trading through historical scenario tests, or even for fixed ‘portfolio performance’ versions. Most traders are vaguely aware of the events of that year, even those who were too young to be involved with the markets, but knowledge of various crashes in the 1970s, 1980s and 1990s is much shakier, and so these scenarios are particularly favoured for stress tests.
Historical stress testing is also uniquely suited to the forex market because currencies (excluding of course the euro – and from 1990 you can use the Deutschemark as a proxy) tend to exist over long periods. Several commonly traded stocks from the 1980s are now either defunct or thinly traded, and when the Dow Jones was first inaugurated it was filled with railroad companies. In stark contrast, the most traded currencies list has barely changed, with the addition of the Renminbi to the top of the leader board the only significant change since the introduction of the Euro. This makes it significantly easier to create accurate simulated portfolios for historical testing.
How Rakuten can help
Market stress forces traders to act to protect their profits, and episodes of stressed markets can occur with little or no warning. To better prepare yourself, why not open a free demo account and start trading today without risking any of your capital?