Put buyers are piling on Russia ETF's
Subscribers to Chart of the Week received this commentary on Sunday, February 27.
If you've been hanging on to every development in the geopolitical theater between Russia and Ukraine over the past month, you probably have whiplash right now. As an investor, it's difficult to glean much from any particular headline -- positive or negative -- because a less-than-constructive development could be right around the corner that throws a wrench in it all. This week's price action is evident of that.
One thing is for sure; financial markets are quite sensitive to brinksmanship. It doesn't take a Rhodes scholar to recognize that war=bad for stocks. But geopolitical posturing – and that's what Russia is doing -- has so many other ancillary effects that a cheat sheet of sorts could help investors articulate the cause-and-effect of every development. We're going to try to unpack the bigger ones below.
Let's get the obvious ones out of the way; safe-haven assets get gobbled up amid geopolitical tensions and gold futures are on track for their best weekly win in nine months, while the 10-year Treasury yield ticks below 1.95% at last check. You can also tie the VanEck Vectors Russia ETF (RSX) to U.S. indexes in that they both benefit from de-escalation. The RSX gained 5.8% on Feb. 15, following reports that Russian military units were returning to their bases after exercises near Ukraine. However, the index then shed 4.9% after the U.S. Ambassador to the United Nations noted the conflict had reached a "crucial moment" and that Russia is moving toward "an imminent invasion. "
RSX has seen around $120 million inflows in the last two weeks, per ETFTrends.com. Around 40% of the fund's $1.4 billion in assets is dedicated to energy, with gas and oil representing about 16%-18% of the fund itself. Looking below at recent action at the International Securities Exchange (ISE), Cboe Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX), traders have mostly been buying to open RSX puts, with the 10-day put/call volume ratio coming in at 2.79 and ranking in the 81st percentile of its annual range. Per the chart below, you can see the pop in puts earlier in January coincides with U.S. and Russian officials meeting in Geneva for diplomatic talks, talks that subsequently broke down and have led to the current predicament.
I want to amend my previous statement and say that war = bad*, with the asterisk for American defense stocks such as Northrop Grumman Corporation (NYSE:NOC), Lockheed Martin Corporation (NYSE:LMT), and General Dynamics Corporation (NYSE:GD) that typically enjoy tailwinds as war clouds gather. Since satellite imagery showed a fresh build-up of Russian troops along the Ukraine border on Nov. 1, NOC, LMT, and GD boast respective three-month returns of 12%, 13.8%, and 9.9%. In the last 50 days, bought-to-open calls have outnumbered puts by a nearly two-to-one ratio for all three of the defense stocks. However, options traders are paying a pretty penny for these names now, per their implied volatilities (IV) that all sit in middling percentiles of their annual ranges.
The U.S. has already declared it will block it’s not-yet-operational Nord Stream 2 pipeline should Russia advance into Ukraine. Although the energy sector has been resurgent in the last nine months, per the chart below, put traders have been crowding the broader Energy Select Sector SPDR Fund (XLE) lately, despite its 22% year-to-date gain. Meanwhile, calls are popular among the specific United States Natural Gas Fund (UNG).
The reason why many pundits view potential U.S. sanctions against Russia as an ineffective negotiation tactic, is because Europe has become increasingly dependent on Russia for its natural gas. Should this dependence get squeezed, investors should be keen to see what steps up as a replacement, a decision that is sure to have a ripple-effect on the energy sector. Perhaps those UNG call buyers are reading the same tea leaves.
The x-factor in this entire geopolitical mess is China, which has brazenly strengthened its alliance with Russia in recent months. Project-Syndicate summarized China's triangulation gambit, noting "this new marriage is convenient in both economic and geostrategic terms. Russia has the natural gas that an energy-hungry, coal-dependent, polluted China needs. And China, with its surplus savings, ample foreign capital, and its Belt and Road Initiative, offers Russia added clout to buttress its thinly-veiled territorial ambitions."
If a diplomatic breakthrough is not on the horizon, it could mean more strain to U.S-Sino relations. There's no clear view of what will happen and its impact on China-listed stocks stateside, but using options limits your capital at risk compared to stock trading. With some of the information above, pairing two diametrically opposed directional plays provides a built-in "hedge" against macro headwinds while simultaneously creating multiple possible paths to profit. In short, investors should consider options if and when the geopolitical floor shift beneath them.