Raising the bar

Leverage effect: the right definition and explanation

The guide by Andrew Patton for Quantitative Finance FN3142 states that "stock returns are negatively correlated with changes in volatility: that is, volatility tends to rise following bad news (a negative return) and fall following good news (a positive return)", with reference to Black (1976). This is not quite so, as can be seen from the following chart.

S&P500 versus VIX: leverage effect

The candlebars (in green and light red) show the index S&P 500, which is an average of the stock prices of the largest 500 publicly traded companies. The continuous purple line shows the VIX, one of widely used measures of volatility. Between the yellow vertical lines at A and B the return has been predominantly positive, yet in the beginning of that period the volatility has been high. The graph clearly shows that there is a negative correlation between asset prices and volatility, not between return and volatility. Thus the proper definition of the leverage effect is "negative correlation between asset prices and volatility". There are different explanations of the effect, here is the one I prefer.

At all times, market participants try to maximize profits and minimize losses. This motivation results in different behaviors during the market cycle.

Near the bottom (below line at E)

During the slump to the left of point A. Out of fear that a great depression is coming, everybody is dumping stocks, trying to stay in cash and gold as much as possible. That's why the price drops quickly and volatility is high.

During the recovery to the right of point A. Some investors consider many stocks cheap and try to load up, buying stocks in large quantities. Others are not convinced that the recovery has started. Opposing opinions and swift purchases, made possible by large amounts of cash on hands, increase volatility.

Near the top (above line at F)

To the left of point B. Stocks are bought in small quantities, for the following reasons: 1) to avoid a sharp increase in price, 2) out of fear that the rally will soon end, and 3) not much cash is left in portfolios, so it's mainly portfolio rebalancing (buy stocks with potential to grow, sell those that have stalled).

To the right of point B. Investors sell stocks in small quantities, to take profits and in anticipation of a new downturn.

The main difference between what happens at the bottom and at the top is in the relative amount of cash and stocks in portfolios. This is why near the top there is little volatility. Of course, there are other reasons. Look at what happened between points C and D. The S&P level was relatively high, but there was a lot of uncertainty about the US-China trade war. Trump with his tweets contributed a lot to that volatility. This article claims that somebody made billions of dollars trading on his tweets. Insider trading is prohibited but not for the mighty of this world.

Final remark. If the recovery from the trough at point A took just three months, why worry and sell stocks during the fall? There are three answers. Firstly, after the big recession of 2008, it took the markets five years to fully recover to the pre-2008 level, and that's what scares everybody. Secondly, the best stocks after the recovery will not be the same as before the fall. Thirdly, one can make money on the way down too, provided one has spare cash.