What Geopolitical Conflict Means for Investors

Note that investors should judge political decisions based on constraints, rather than on preferences. Constraints always determine the action.^[7]

Figure 1.  Global Grain Trade

The current geopolitical conflict in Ukraine spells bad news not just for Ukrainians but for the outlook for investors, too.  Over the weekend, the US and western allies said:^[3]

They will place sanctions on Russia’s central bank and remove some of the country’s lenders from the Swift global financial messaging system, in their harshest response yet to the invasion of Ukraine.

Sanctioning the Central Bank of Russia could prove devastating — the true "nuclear" option in the West's financial arsenal.

Russia currently holds about $640 billion in reserves. About 32% held in euros, 22% in gold, 16% in dollars, and 13% in Yuan.

As Elina Ribakova, deputy chief economist for the Institute of International Finance, said: 

Sanctioning Russia’s central bank is likely to have a dramatic effect on the Russian economy and its banking system, similar to what we saw in 1991 (see Fig. 1).

 

Figure 2.  $RTSI (similar to MOEX Russia Index) and RSX (Courtesy of stockcharts.com)

More Inflation and Slower Growth Expected

As James Mackintosh warned that "investors should pay close attention to the long-run shifts that Russia’s move will intensify, because they probably mean more inflation and slower growth. They come in three parts:^[1]

1. More military spending expected
• Which means less spending on other parts of the economy
2. Less globalization expected
• It means higher energy prices and domestic sourcing, which could hurt profit margins
3. Geopolitics is scary again
• More countries may want to secure nuclear weapons as a nuclear deterrence
• Geopolitical tension also has a tendency to spread

Figure 3.  Oil and Natural Gas Trades in Asia (Source: @Albert Park)

Impact of the Russia-Ukraine War on Asia’s Economies

The Russia-Ukraine war will increase food prices:

• Russia and Ukraine supply 22% and 18% of global wheat and barley exports, Ukraine supplies 15% and 12% of global rapeseed and corn exports, and Russia supplies 12% of global fertilizer exports.

In addition, 

• Russia and Ukraine together produce 1/3 of palladium and the vast bulk of the neon used in semiconductor production
• The latest sanctions will also affect trade in metals like aluminum, nickel where Russia is a major producer

As @Albert Park summarized:

The impact of the Russia-Ukraine war on Asia’s overall trade is expected to be limited, as Russia and Ukraine account for only 2.5% of Asia’s imports and 1.5% of Asia’s exports. Developing Asia also accounts for only 5% of FDI in Russia. 

However, the biggest impact of Russia-Ukraine war on Asian economies will be higher oil and gas prices, which will fuel inflation and slow growth in energy-importing countries, but help net exporters (see Figure 3).

Figure 4.  Cost of living expected to rise sharply in many countries as energy & food prices skyrocket (Source: @Gita Gopinath)

References

1. What Russia’s Invasion of Ukraine Means for Investors
2. Long-Term Investments: Morgan Stanley's 30 for 2019
3. West to impose sanctions on Russian central bank and cut some lenders from Swift
4. The Last The Ruble Crashed Like This, LTCM Collapsed
5. Stocks Tied To China's SWIFT Alternative Are Soaring
6. Ukraine war disrupts global market for grains
• Black Sea port closures threaten food supplies around the world
  
7. 3 Dividend Stocks To Buy When 98% Of CEOs Predict A Recession In 2023
8. Natural Gas Weekly Update (EIA)
9. World Oil Supply Set To Decline In Coming Decade?

Technical Analysis—Bullish Percent Index

Figure 1.  $SPX Bullish % Index on 02/25/2022 (thrust: > 75% and washout: < 25%; Source @mark_ungewitter)

Mark Ungewitter has posted the below comments on $BPSPX (i.e., S&P 500 Bullish Percent Index) on Twitter (See Figure 1):

$SPX still lacking breadth washout, defined by BPI <25%.

 

Figure 2.  Similar chart (Courtesy of stockcharts.com)

 

It is also interesting to see that @MrBlonde_macro has posted the below analog chart (2022 vs 2018) which also says that the real bottom of market probably is not in yet.  So, it's worth monitoring.

Figure 2.  Analog of stock markets of 2022 vs 2018 (Source: @mrblonde_macro)

Gold Investments During Rate Hike Periods

 Real Interest Rate

The real rate is the return after inflation—generally regarded as the 10-year Treasury minus the CPI. Why do the real interest rates matter for gold?  Here are the reasons:^[1]

• Holding cost
• Includes storage and insurance of gold
• Opportunity cost
• Instead of holding gold, investors could be lending it (or the cash spent) out. The higher the real interest rates, the larger are the opportunity costs of investing in gold.
• And the lower real interest rates, the smaller are the opportunity costs, so people are more eager to hold more gold. 

In particular, the negative real interest rates are gold's real friends (the 1970s or the post-Lehman era are the best examples).

 

Figure 1.  Gold and real-yields (inverted) have decoupled from their historic relationship (Courtesy of stockchart.com; 02/16/2022)

Gold—a Geopolitical Hedge of Last Resort

However, historically gold tends to increase during rate hike periods when gold’s negative correlation with long term real rates also tends to break down (see Figure 1):^[2] 

This is already happening with gold displaying resilience to the most recent increase in US 10 year real rates. In our previous research, we argued that this has to do with the fact that the rate hikes themselves can lead to fears of a growth slowdown and recession and therefore boost demand for safe haven assets, such as gold. This means if inflation fails to slow down in the second half of 2022 and the Fed is forced to hike more than currently expected, gold should be resilient as this would increase fears of a potential recession. And Goldman believes believe that gold is a geopolitical hedge of last resort.

 

Warning

But, gold investment is complicated^[4] and its market could be very volatile as @SuburbanDrone had warned on 02/21/2022: 

For now I'm ignoring these futures oscillations due to various Ukraine rumors. On the topic of gold, I'm not bullish at these levels (see Figure 2), recent out-performance notwithstanding.

 

Figure 2.  Long-term Gold Price (Courtesy of stockcharts.com)

 

References

1. 3 Drivers Of Gold
2. Gold Is The Geopolitical Hedge Of First Resort, Goldman Sees $2150 Within 12 Months (posted on 02/14/2022)
3. Stocks, Bonds, & Bitcoin Dump'n'Pump As 'Meh'-Minutes Reverse Russia-Rout
4. Gold Investment— All Things Considered
5. How Debt Jubilees Work 
• Suffice to say, my main plan (i.e., Lyn Alden Schwartzer) throughout this period is to mainly hold scarce assets- things like productive cash-producing companies, commodities, real estate, and hard monies, rather than being too heavily invested in fiat currency or bonds at any given time other than for some liquidity and optionality. 
6. Flows show recession risks are rising - BofA (02/21/2022)
   

Gamma and Gamma Exposure—Knowing the Basics

In 2021, $SPX options make up 16% of the $SPX market cap.  To hedge a book of $SPX options, the primary risk-management technique is delta hedging, which is when option traders start messing about in the equity markets. 

Some may recall the Gamestop ($GME) saga that took place earlier this year - Much of this bizarre and explosive move was attributed to Gamma Exposure (GEX), which was a prime example of how the mechanics of gamma exposure can influence market action in a very powerful way.

 

Chart 1.  Estimated SPX Dealer Gamma Exposure - All Expirations (Source: @t1alpha)

Option Greeks

 

An option's price can be influenced by a number of factors that can either help or hurt traders depending on the type of positions they have taken.^[1]

Successful traders understand the factors that influence options pricing, which include the so-called "Greeks"—a set of risk measures so named after the Greek letters that denote them, which indicate how sensitive an option is to time-value decay, changes in implied volatility, and movements in the price of its underlying security. For example, two of the four Greeks are:

Delta—is a measure of the change in an option's price or premium resulting from a change in the underlying asset.

Gamma—measures delta's rate of change over time, as well as the rate of change in the underlying asset. Gamma helps forecast price moves in the underlying asset.

Delta Hedging

 

In general, hedging is a strategy used to reduce risk. An investor hedges a position in a particular security to minimize the chance of a loss. The nature of a hedge, though, also means the investor will give up potential gains as well.

Delta hedging is a strategy in which an investor hedges the risk of a price fluctuation in an option by taking an offsetting position in the underlying security (stocks or futures).

To initiate a delta hedge you need to first understand what delta is, how it works, and know the delta value for the option you hold.^[4]

Assume a call option has a delta of 0.5. That means the price of the call option will increase by 50 cents for every $1 increase in the price of the underlying stock that the call option is written on. Now suppose you have purchased a call option on that stock for $5 and the price of the stock is $60. If the stock’s price rises to $65, then the options price will rise to $7.50.

An investor can hedge delta risk, for example, by buying the call option, then short-selling the underlying stock. The amount of the underlying stock that must be sold to exactly offset the delta risk is based on the delta.^.[5]

If the delta is 0.5, then the investor needs to sell half of the number of securities that are covered by the call option contract. Since a typical option contract covers 100 shares of the underlying security, the investor would need to short 50 shares of the underlying stock to have a delta-neutral position.

The amount of delta-hedging needed is mainly dependent on this thing called gamma. 

How to Find Spot Gamma?

 

In our daily observations of (bizarre) market moves, we frequently analyze the delta-hedging of option positions by dealers (or market makers), i.e. gamma, which has emerged as one of the dominant drivers of risk assets. But why is gamma important, especially in option-expiration weeks? 

Gamma has the potential to be one of the most important non-fundamental flows in equity markets (particularly when “short gamma” causes volatility to accelerate), but tracking gamma is complex and dynamic.^.[6]

You can find out spot gamma which shows the gamma exposure at the current spot level in 2 ways:

• Provided by Option Chain (e.g. CBOE)
  
• Sometimes it's provided on the option chain, along with implied volatility (IV) and deltas.
• Otherwise
• Need to calculate it manually (see the section "How to Construct Spot Gamma Using Excel?" below)
  

 

Chart 2.  Gamma Exposure Profile, $SPX (02/01/2022; Source: @perfiliev)

Gamma Exposure Profile

 

Our goal here is to find out two things:

1. How much gamma the dealers are sitting on across the index levels
2. What's their current total gamma exposure

In Chart 2, it shows an approximate amount of dealer hedging flows across index levels:

• Short gamma to the left
• Long gamma to the right

Two levels are notable on this chart:

1. Current Spot Gamma Exposure—where Total Gamma Exposure blue line crosses the current spot red line
• Occurs at around -$19Bn in this chart and it means that Option dealers need to SELL $19Bn worth of $SPX index for each 1% move DOWN, and BUY $19Bn for each 1% move UP.
  
2. Zero Gamma Level (or Gamma Flip)—where Total Gamma Exposure blue line crosses zero
• On the chart, it occurs at around 4,574 $SPX level. This is the Zero Gamma level, where the dealer gamma exposure flips from positive to negative.  
• Above this level, dealer hedging flows are stabilizing and add liquidity to the market. Below this level, dealer hedging flows are destabilizing and add to the volatility instead. 
• At this level, flows are zero, as delta doesn't need re-balancing due to spot moves.  

You can read [8] to understand more on "What is Gamma, Market Gamma and/or Total Market Gamma?".

 

How to Construct Spot Gamma Using Excel?

To construct spot gamma, you need:^[2]

• Options data
  
• Strikes, expiries, and open interest (OI) are needed
  
• For US stocks, CBOE provide their delayed quotes (link).
• Search for "SPX" → click on Options tab → set Options Range = All → set Expiration = All → click View Chain
• To download the entire options chain, scroll all the way down, and click on Download CSV.
• Note that open interest figures are updated once per day and it's better to download them during market hours. 
• Excel
• First, we need to calculate the unit gamma for each option and then sum them up across strikes and expiries

But, you also need to make the below assumptions:

• On an index level
• The dealers are long the calls and short the puts and we'll assume that calls carry positive gamma and puts negative
• On single-stocks
• It's more debatable as the street can be short the calls due to some speculative buying frenzy
  

For details, please follow Sergei Perfiliev's article.^.[2]

References

1. Option Greeks: 4 Factors for Measuring Risk
2. How to Calculate Gamma Exposure and Zero Gamma Level
3. CBOE Data
• Cboe offers trading across multiple asset classes and geographies, including options, futures, U.S. and European equities, exchange-traded products (ETPs), global foreign exchange (FX), and multi-asset volatility products.
4. Options Delta—The Greeks
5. Options Knowledge Center 
6. Goldman: All You Ever Wanted To Know About Gamma, Op-Ex, And Option-Driven Equity Flows
7. Gamma & Gamma Exposure - What Traders Need to Know
8. What is Gamma, Market Gamma and/or Total Market Gamma?
9. Gamma Exposure Dashboard
10. When Markets Are Wild, Embrace Liquidity
11. Socially Acceptable Volatility Redux
12. Liquidity Considerations Ahead of a Three-Day Weekend
    

Average True Value—Knowing the Basics

Commodities are frequently more volatile than stocks. They were are often subject to gaps and limit moves, which occur when a commodity opens up or down its maximum allowed move for the session. As shown in the below chart, @SuburbanDrone has chosen Average True Range (ATR) to represent WTI Crude Oil's volatility.

In this article, we will cover the basics of ATR. (or Realized Volatility used in commodities market).

Chart 1.  WTI Crude Price shown with Realized Volatility (or ATR; Source: @SuburbanDrone)

Average True Range (ATR)

 

Average True Range (ATR) is an indicator that measures volatility.  It was developed by J. Welles Wilder who designed ATR with commodities and daily prices in mind.^[1]

A volatility formula based only on the high-low range would fail to capture volatility from gap or limit moves. Wilder created Average True Range to capture this “missing” volatility.

ATR Values Are Not Comparable

 

ATR is based on the True Range, which uses absolute price changes.^[1]

As such, ATR reflects volatility as absolute level. In other words, ATR is not shown as a percentage of the current close. This means low-priced stocks will have lower ATR values than high price stocks. For example, a $20-30 security will have much lower ATR values than a $200-300 security.

Because of this, ATR values are not comparable.

It is important to remember that ATR does not provide an indication of price direction, just volatility:^[1]

ATR is not a directional indicator like MACD or RSI, but rather a unique volatility indicator that reflects the degree of interest or disinterest in a move. 

Strong moves, in either direction, are often accompanied by large ranges, or large True Ranges. This is especially true at the beginning of a move. Uninspiring moves can be accompanied by relatively narrow ranges. 

As such, ATR can be used to validate the enthusiasm behind a move or breakout. A bullish reversal with an increase in ATR would show strong buying pressure and reinforce the reversal. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break. 

References

1. Average True Range (ATR) 

 

Tech and Housing Bubbles in One Chart

Figure 1.  Tech and Housing Bubbles in One Chart (Source: @SuburbanDrone)

 

Footnotes of Figure 1

• @Home
• Case Shiller Home Price Index (via Fred)
• $SPT
• S&P 500 Information Technology Sector Index INDX
  
• !RYRATMM
•  Rydex Asset Ratio—Bear + MM Assets/Bull Assets (NBD) INDX
• $ONE:!RYRATMM (or Inverse of !RYRATMM)
• Rydex bull/bear asset ratio