With the overnight action in the ES futures, my measure of pure volatility--the amount of movement generated by a fixed amount of volume; see chart above--has risen to its highest level since the October lows. The same amount of stock index volume is now generating more than twice as much movement as late in December. What pure volatility tells us is that we don't need specific event risk to see dramatic increases in market movement. During recent market selloffs we've seen both more volume and more volatility per unit of volume.
This is why stress-testing your positions and portfolios is a best practice in trading. Consider the position(s) you currently hold and your intended holding period for that position or positions. Now look back over the past two years of trading and identify the worst drawdowns that could have occurred to that position or portfolio over the course of that holding period. Because financial returns are not normally distributed, the odds of outsized losses are greater than we would expect from usual statistical analyses. Looking back over a period of years and identifying worst possible drawdowns is at least a beginning heuristic to let you know if you could survive a significant event risk or adverse move.
If the loss you would incur from worst case gap/event risks or drawdowns would impair your trading account and impair your trading, you know that your risk-taking amounts to a kind of Russian roulette. It is only a matter of time before an active trader encounters a two-plus standard deviation adverse move. Sizing positions to survive stress tests is immensely important to longevity in a trading career.
Sizing is not a total solution, however. Even reasonable sizing wouldn't have protected you from the kind of multi-multi standard deviation move we just saw in the Swiss franc. This is why diversification in a portfolio is essential. When one position blows out, other positions have the opportunity to work in your favor. Spreading risks that are sized properly helps protect traders and investors from those rogue moves that are associated with fat tails of financial returns.
You can't win the game if you can't stay in the game. The trading literature is filled with admonitions to size up trades and portfolios when you have confidence in your views. Flash crashes happen. Downside gaps on negative earnings surprises happen. Spikes in volatility happen. Confidence not tempered with prudence is an accident waiting to happen.
Further Reading: Mistakes in Risk Taking
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