In theory, volatility may rise during both an increase, and decrease in an assets price. For example, a rapid rise in the price of a stock should lead to an increase in volatility. However, anyone who’s traded equity options knows that volatility in such a scenario usually remains subdued. Instead, equity volatility typically rises as the price of a stock falls.
In essence, the reason for this is fear. Humans fear losses more than they yearn for gains. This is why panic grips market participants in bear markets, while bull markets tend to be controlled ascents. Or, in other words: the stock market takes the escalator up, and the elevator down.1
This is also why implied volatility explodes as the price of a stock falls. Owners, and speculators, fear sharper and larger losses and are therefore willing to pay more for protection. As the demand for put options increase, implied volatility rises and put writers can claim higher premiums.
The crazy world of crypto
But all of this is in the developed world of equities. In the wild west of crypto, it is said that volatility acts in a slightly different manner.2 For example, many believe that Bitcoin volatility, or BVOL, has a tendency to rise together with the price of Bitcoin – more so than is the case in equities.
A psychological analysis of this theory leads to the conclusion that crypto market participants are extremely afraid of missing out on potential profits, sometimes more so than they fear losses. In other words, if the theory holds, greed and FOMO seem to dominate the crypto markets.
But is greed really the true driver of crypto market volatility? Using bitcoin as a basis for reaching a conclusion, the answer is: it depends on the time frame used to measure volatility. Comparing the 30-day historical volatility of Bitcoin with its price leads to the conclusion that greed has indeed been a driver of volatility.
And this may have indeed been the case during Bitcoin’s infancy. However, measuring volatility on a shorter terms basis leads to the opposite conclusion, i.e. that volatility increases as the price of Bitcoin falls. The explanation for this paradox is simple, since the 30-day historical volatility is lagging and historical drawdowns have been followed by quick reverseals, the slower volatility measure gives the impression of volatility rising together with price. In fact, we need only zoom into the 1-year historic chart to see how volatility explodes during drawdowns in price.
Volatility clearly explodes during the major drawdowns of 2018. This effect is made even more clear on a 24-hour basis. As ownership increases, and as a liquid options market evolves, we expect that fear becomes the major driver of Bitcoin volatility — just like in the equit markets.
- The high share of ownership and the importance stocks have for individuals and institutions in the developed world undeniably strengthens this loss aversion. ↑
- Only historical, i.e. past volatility, can be accurately measured as of this writing as Bitcoin and other cryptocurrencies lack liquid options markets where implied, i.e. expected volatility, can be measured. ↑