War and Volatility – Long Term Market Effects
By Brett Friedman
As is usually the case with warfare, its progress has been unpredictable and even surprising. Yogi Berra said it well: “It’s hard to make predictions, especially about the future.” The Russians, along with most foreign policy, defense and strategy experts, initially speculated that their forces would quickly and easily overwhelm Ukraine and that Putin and his new nomenklatura would emerge victorious.
Needless to say, it didn’t quite turn out that way. Ukrainian resistance is more widespread, and the Russian military faces serious logistical, tactical and leadership problems. It is a major understatement to say that, as usual, the consensus was wrong and the outcome unclear.
The number of options traders who have experienced the onset of geopolitical hostilities seems to be decreasing every year (and that’s a good thing, because it means protracted wars are becoming less frequent). Institutional memory fades and lessons learned the hard way, such as the peculiarities of analyzing and trading options in an environment where an extreme fundamental shock dominates the market, are forgotten. The effects are not obvious, generally run counter to consensus, and are sometimes counter-intuitive. In short, the short-term effects can hold some interesting surprises, and the long-term effects aren’t as drastic as one might think.
Short-term effects on the market: crude oil volatility acts abnormally
Russia’s economy is commodity-based (crude oil, natural gas, coal, wheat, and base and strategic metals), so it’s no surprise that related futures markets have shown the greatest short-term effects. both on the underlying prices and on the implied volatility. Some examples :
Crude oil (WTI) futures experience implied volatility shocks commonly seen during times of major geopolitical, societal and financial disruptions: Gulf Wars I and II, 2008 financial crisis, outbreak of Covid and oil prices negatives. Given the severity and potential of the Ukrainian war, this is not surprising.
Historically, crude oil’s implied volatility tends to rise fastest and steepest when prices are falling rapidly. Indeed, the highest implied volatility on record for crude oil (198.25%) occurred in April 2020, when the first-month futures price temporarily turned negative during the trading session. Conversely, when crude oil prices rise sharply, the upward response in implied volatility (IV) tends to be more subdued. This behavior has obvious implications for options strategy and crude oil positioning.
The Ukrainian war is obviously affecting the market, but its effect on implied volatility has not been as impressive. Since the beginning of last December, around the time news of the war started to affect the market, crude has peaked at $121.47, an increase of around $56. At the same time, implied volatility rose only 19.3% to its high. It’s even lower now: with a market increasingly accustomed to war, Crude IV has only posted a 4% gain since early December. However, this is somewhat misleading, as we will see below.
Converting daily implied volatility values to its implied daily price range yields a range that is the highest since 2007, and by a wide margin:
The high implied daily price range is not displayed in natural gas:
For crude oil, this suggests that the current implied volatility levels are probably not warranted given the anomalous implied range.
Long-term effects on the market: not what you might think
Despite the current uncertainty and accompanying anxiety, the Russian-Ukrainian conflict should be kept in perspective. As the table below indicates, the long-term effect on financial markets of war and other severe shocks is not as significant as one might think.
- Geopolitical shocks that cause truly long-lasting effects on equity markets (i.e. more than about three months in the S&P 500, from trough to rally) are rare: only two out of 21 events, Pearl Harbor and the First Gulf War, have qualified in the last 81 years.
- Pearl Harbor, one of the most significant events of the 20th century, caused the market to fall just under 20% (a level generally perceived as a bear market). Even so, the market recovered in less than a year, and you can’t be much more shocked than WWII.
- Geopolitical shocks require pre-existing economic conditions and must be truly global in nature to have a lasting effect. In other words, they tend less to alter the underlying trend than to act as a catalyst for factors that have weighed on the market before. For example, in the current context, the war in Ukraine has served to accelerate the inflationary trend already established before the war.
Originally posted on MoneyShow.com
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.