What Is the Asymmetric Volatility Phenomenon (AVP)?
The asymmetric volatility phenomenon (AVP) is the observed tendency of equity market volatility to be higher in declining markets than in rising markets. This means that volatility will increase more given a 10% drop from current price levels than given a 10% gain.
Market psychology plays a role in this phenomenon since people can overreact with fear or panic to selloffs. There is also a more natural tendency to protect positions against downside losses rather than selling upside gains in the shorter term.
- The asymmetric volatility phenomenon (AVP) is the observance that volatility increases more when prices fall than when prices rise by a similar amount.
- AVP is considered to be a market anomaly since rational actors in efficient markets should treat up and down swings identically.
- Some have attributed AVP to market psychology such as loss aversion, or to the need to protect downside losses far more than upside profits.
- Because volatility is asymmetric in this way, options prices include a skew or "smile," with downside strikes typically having greater implied volatilities than higher ones.
- The logic is that people, in aggregate, care about buying downside insurance more than upside speculation.
Understanding the Asymmetric Volatility Phenomenon (AVP)
Asymmetric volatility is a real phenomenon: market uptrends tend to be more gradual and downtrends tend to be sharper and steeper and become cascading declines. And the daily range in prices tends to be higher during downtrends than uptrends.
However, there is no consensus about what causes it. One explanation is that trading leverage leads to margin calls and forced selling. Other explanations come from the field of behavioral finance, like behavioral feedback loops in which certain behavior incites more of the same behavior and panic selling.
People are subject to loss aversion, according to behavioral economics and prospect theory, developed by Kahneman and Tversky in 1979. In other words, they prefer avoiding losses to acquiring equivalent gains. Some studies suggest that losses are twice as powerful, psychologically, as gains. This bias skews our assessments of probability.
For example, prospect theory also accounts for other illogical financial behaviors, such as the disposition effect, which is the tendency for investors to hold onto losing stocks for too long and sell winning stocks too soon. Building on the work of Kahneman and Tversky, evolutionary psychologists have developed theories regarding why the assessment of risks and odds are inseparable from emotion—and why loss aversion might cause asymmetric volatility.
One of the difficult factors in identifying the causes of asymmetric volatility is separating out market-wide (systematic) factors from stock-specific (idiosyncratic) factors. Loss-aversion theory has evolved into the asymmetric value function.
The existence of asymmetric volatility plays an important role in risk management and hedging strategies as well as options pricing. Because of AVP, there is a volatility smile or skew, whereby lower-strike options, on average, have greater implied volatilities (IV) than higher strikes. Some traders attribute the introduction of AVP into options pricing to the Black Monday stock market crash of 1987.
AVP is considered to be a market anomaly since if markets were efficient and market participants rational actors, volatility should not be affected by whether prices moves are to the upside or the downside.
What Is Asymmetric Investing?
Asymmetric investing seeks to capitalize on potential payoffs that exceed potential losses. Examples can include buying an options contract, where the downside is limited to the premium paid for the contract.
Is Low Volatility or High Volatility Better for Trading?
This depends on what type of trader you are. Day traders and swing traders benefit from increased volatility, while trend followers and buy-and-hold investors usually prefer steady gains over time. Using various strategies involving derivatives contracts, a trader can make money from either a high or low volatility environment.
What Options Are Best to Buy in a Volatile Market?
Options prices tend to rise with market volatility, whether they be calls or puts. Moreover, longer-dated options contracts are more price-sensitive to changes in volatility. Therefore, if you believe that markets will increase in volatility, you can buy longer maturity options strategies, such as a straddle or strangle.
What Are the Types of Volatility?
Volatility can be assessed in several ways. Realized or historical volatility is how large and fast price swings have been in the past. Future volatility is what they are expected to be in the future. Implied volatility (IV) is the expectations of volatility signaled by options prices in the market.