(G)ARCH - 101

(G)ARCH: (mandatory) basic knowledge

(G)ARCH is short for Generalized Autoregressive Conditional Heteroskedasticity. It sounds complicated, but it’s really a simple concept; volatility tends to cluster. Okay, I believe you, but so what? Why does volatility cluster? You never hear the answer to that question from the Kwants 😉.

I’m gonna lay it out in simple terms. However, we are going to have to draw some terminology from System Dynamics in order to get our point across. The movement of natural systems (markets, weather, viruses, etc.) are subject to initial conditions, feedback flows and networking-effects. For GARCH, let’s assume we start-off with a medium-vol, sideways market. As market prices begin to rise, and volatility starts to dampen, you create a signal (Sharpe or Information Ratio) that grows stronger as more agents see it and act upon it. That agent-based behavior creates self-reinforcing positive feedback which attracts other agents and becomes a networking effect where many diverse agents are acting on the signal for different reasons yet creating the same output. This positive correlation between the signal and price/volatility continue until the signal is very strong & the theme (trend) becomes saturated. Then the correlation begins to drop towards zero as there are no more marginal agents to join the crowd. Now the system is ripe for a phase-transition (reversal).

Next, some random event causes the reaction function to pervert and the feedback flows become negative and self-correcting. Prices begin to get choppy and volatility rises which leads to lower signal which drives position unwinds. This process repeats and creates a networking effect in the opposite direction until the correlation between lower prices & volatility drops to near zero. The cycle is now complete. See pic below for a visual representation of the cycle from a high-vol/position unwind mkt to a low-vol/trending risk-on mkt.

My research on agent-based feedback flows are what we teach our members at The Delta House. They learn to be prepared to take advantage (monetize) of both trending/vol-dampening regimes as well as choppy position unwind/vol-expansion regimes.

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