Riding Out Geopolitical Risk

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Riding Out Geopolitical Risk

By Brian Benson, On Course with Options


In my recent blog post, “Selling Options On Oil”, I made mention of “geopolitical risk” in oil markets.  This is probably a term that we’ve all been hearing a little too much of lately. But, here we are starting out the 2020 trading year with a rather significant geopolitical situation immediately front and center.

While almost everyone is hoping for further de-escalation and for cool heads to prevail, the answer to how this ultimately plays out is nobody knows. We cannot forget just when we think it might be over, a new action/reaction may again suddenly spike volatility in markets.

Whether it’s geopolitical risk or some other type of statistically rare “Black Swan[1]” event, these things happen and are a part the randomness of trading and investing. You’re likely to encounter numerous instances of extreme volatility events of various kinds over your trading career.

Our goal as traders is to protect and grow our trading capital meaning we must check our emotions (i.e. fear and greed), so we can focus on accurately observing and responding to what is actually happening in the markets we trade.  That can be a real challenge when normal market forces are suddenly pushed aside and geopolitical events become the drivers of markets.


Initial Reaction
The initial reaction to an unexpected incident typically reflects classic crowd psychology[2]. A fear mentality takes over and many investors and traders immediately want to rush to the exits. Sometimes they don’t have a choice and are forced out of positions with margin calls.  We often don’t know the best response until we can see events fully play out and have the benefit of hindsight.

As might be expected in times of panic, S&P futures tend to tumble when news of a significant crisis breaks. Oil may shoot up as an initial reaction out of fear of supply disruptions. Gold and bonds can spike as they’re generally regarded as a safe havens in times of trouble.


What’s Past is Prologue?
While the current situation between Iran and the US may be far from fully played out, it can be useful to compare how markets have behaved in recent extreme volatility events.

The September 14 missile attack on Saudi oil infrastructure crippled half of their oil production, or roughly 5 percent of world oil capacity. Simply stunning. The upside reaction in oil prices was sudden, severe and surprisingly brief. While we might have expected a sustained price increase, the very next day oil retraced the initial response and then proceeded to fall another 12 percent in the following weeks.

Although we might think such Middle East events would cause a drastic increase in the price of oil with some follow-through, that has not been the case either with the Saudi attack in September or with the recent open conflict between the US and Iran.

What we’ve been seeing is the initial reactions have been rather short-lived, at times completely reversing within 24 hours or less. Stocks have proven resilient with the ability to bounce back quickly.  Oil has proven vulnerable to downtrend reversals as concern quickly shifts back to oversupply risk.

Although we cannot count on these quick reversals to continuing, it does give us some indications of the resiliency of underlying current market sentiment.


Positioning Ahead of Time
Extreme volatility events can happen suddenly. We can afford ourselves some protection by how our trading accounts are structured ahead of time.

These are not recommendations, but rather strategies and tools to consider that may or may not be suitable for your particular style of trading.

Perhaps the single most valuable strategy is to stay small with our position size. Position size that is too large is right at the top of the list of things that blow traders up. Not letting position size get too big is a core discipline to maintain as a trader.

Another strategy is to diversify across and not just within asset classes. A portfolio of stock positions may not lend great diversification in the face of overall market or systemic risk. Gold and bonds tend to be less correlated with stocks and, at times, can be very inversely correlated to stocks. Other commodities such as oil can be more directly affected and seek their own direction.

Be mindful of overall portfolio directional risk. I monitor directional risk with deltas. I use beta-weighted deltas in stock portfolios and unweighted deltas in commodity portfolios. Many trading platforms have beta-weighting functionality built-in. Many traders beta-weight against SPY, the very popular ETF for the S&P 500 Index. That can be a great way to normalize the differences between individual stocks and have a better idea of how an overall portfolio may perform for a given size move.

There’s an old Warren Buffett quote:
“Only when the tide goes out do you discover who’s been swimming naked.”

If you sell naked options, consider the use of ratio spreads that can dampen your portfolio volatility. This can be particularly helpful in a futures account that uses SPAN margin and could be subject to rapid margin expansion. A more robust alternative is to fully define risk with vertical spreads. Margin may expand, but you’ve put a boundary on the worst case. I tend to use a combination of naked options, ratio and vertical spreads to manage my overall risk.

Consider hedging your portfolio by carrying some long volatility, such as long puts on SPY or long calls on the VIX. These types of hedges add negative deltas that can offset your positive deltas. Hedging comes at a cost though, so to be considered is the cost to carry, i.e. time decay on long options.


Response as Traders
Our first response to a sudden event should not be out of panic. If we’ve been practicing good account management, diversification, position sizing, etc., we should be in better position to weather a storm calmly.

Sometimes the best response is no response, at least not right away. In the case of many futures and options on futures that trade nearly 24 hours a day, we may be better off closing or adjusting trades during regular daytime market hours when there tends to be more participation, better liquidity and narrower bid/ask spreads.

If we have positions urgently needing to be closed or adjusted, then of course we do what we have to do.

It’s also important to recognize high volatility events can have secondary effects, sometimes with a bit of delay. For example, if a big move forces a lot of margin calls, other traders can be forced out of positions, sometimes at horrible prices. Those involuntary trade closures can in turn have a cascading effect and further drive adverse market moves.


What about new positions?
Opening new positions while an extreme volatility event is in play can be very profitable or very painful.   Being on the right side of the trade is critical.

One choice is to simply wait it out until the news is priced in and markets settle down a bit. Cash is a position, and there’s nothing wrong with that.

As an option seller, I do want to take advantage of times when premium is temporarily over-inflated.   Having plenty of cash available can be key. But, this is not a time for big bets or getting over-extended on margin usage.

If I do open a trade in extreme volatility conditions, I will:

  • Keep it small
  • Take profits quickly
  • Aggressively stop out or manage threatened trades if I’m wrong
  • Don’t assume it’s over as certain situations can remain very dynamic for longer than we might think (keep in mind the possibility of second order effects such as massive margin calls)
  • Continue to assess if the market is headed back to normal or perhaps headed in a very different direction longer term

Let me know your thoughts at Brian@youcantrade.com, in the On Course with Options channel at youcantrade.com, or in my Facebook group “Commodity Options Traders’ Forum.”



[1] The Black Swan by Nassim Taleb

[2]Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay



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