Research Report: Invasion

BY: Richard Croft
On February 24th, 2022, Russia invaded Ukraine. It was an unprovoked invasion orchestrated by a bellicose dictator who wanted to decapitate an emerging democracy. It is the standard playbook for frightened Dictators ruling a disenfranchised population. You cannot have ordinary Russians questioning whether the Ukrainian experiment with capitalism is a better model than a Soviet style autocracy?



On February 24th, 2022, Russia invaded Ukraine. It was an unprovoked invasion orchestrated by a bellicose dictator who wanted to decapitate an emerging democracy. It is the standard playbook for frightened Dictators ruling a disenfranchised population. You cannot have ordinary Russians questioning whether the Ukrainian experiment with capitalism is a better model than a Soviet style autocracy?

Russian citizens have a right to complain. The per capita GDP in Russia is lower than in Romania or Turkey. And while Russia’s per capita GDP is still higher than Ukraine’s, the gap is shrinking. Ukraine’s GDP is now expanding at a faster pace thanks to Western influences that helped diversify Ukraine’s economy and strengthen its military. Putin could not risk domestic contamination from a successful stable democracy on its doorstep.

The Putin solution is to make sure the competition does not prosper. Of course, that is a false narrative. But in Putin’s mind, if his annexation of Ukraine results in it becoming a failed State (like East Germany post World War II), he deals a blow to the West and eliminates the competition.

Putin’s actions are a case study that power corrupts… and absolute power corrupts absolutely. Putin has held the reins of power since 1999 and during that reign, there has been no significant improvement in the lives of ordinary Russians. It is still a country riddled with corruption and so, despite its geographical size, abundance of natural resources and scientific talent, Russia is, by most accounts, a failed State.

Putin justifies his aggression because he believes Ukraine is a part of Russia and the fall of the Soviet Union was a calamity – not unlike the way China views its relationship with Taiwan. Putin’s solution is to re-establish a politically compliant Ukraine while, at the same time, dealing a blow to Western democracies.

In Putin’s mind, citing a poker analogy, he was holding the equivalent of a full house. He believed Europe’s dependency on Russian energy would fracture the NATO alliance and the West would not have the resolve to intervene.

His expectations were not unreasonable, given the previously irresolute NATO and still fawning admiration of former-President Trump. Also, Putin’s previous experience with Biden was tied to the former President Barack Obama’s administration, which tried to restart a dialogue with Russia after the invasion of Georgia and allowed Putin to hold onto Crimea after that illegal invasion. As it turns out, history will record Putin’s confidence as a catastrophic miscalculation.

Say what you will of President Biden, he has provided leadership and resolve. Despite any political cheap shots around the timing of sanctions and the perception of American weakness given the Afghanistan fiasco, he has managed to unite Europe and has made the NATO alliance relevant.

Make no mistake, despite attempts pre-invasion, diplomacy was never an option. Nor would pre-invasion sanctions have been an effective deterrent. Russia’s economy was already struggling under the weight of previous sanctions, which led to an untenable wealth gap and festering discontent with Putin’s leadership.

As we enter the second week of the invasion, Russia has met with fierce resistance. Because of social media and 24-hour cable news, the world, including ordinary Russians, are viewing in real time the heroism among Ukraine’s leadership and its people. Global protests are intensifying, including marches in Moscow and St. Petersburg.

Putin’s aggression has led to major sanctions, now including the exclusion of major Russian banks from SWIFT, the system for managing international interbank transactions. More importantly, the West has frozen the assets of Russia’s central bank, which will make it more difficult for Putin to finance his war machine.

The world is tracking assets of Russian oligarchs within Putin’s sphere of influence. Their assets outside Russia will be frozen and confiscated if earned through illegal means. No-fly zones within the European union airspace will restrict entry from any Russian owned aircraft, including the oligarchs’ private planes.

Most striking is that these sanctions have the support of the twenty-seven member European Union. Make no mistake, these sanctions will in time bite the Russian economy and the fact that Putin is displaying his nuclear fangs suggests that he underestimated the unifying power of a common enemy.

Canada is also playing a pivotal role by suspending all export permits to Russia and sanctioning dozens of officials in Putin’s inner circle, while also cutting off Russian banks from doing business with Canadian firms.

Deputy Prime Minister Chrystia Freeland had harsh words for Putin to go along with the sanctions. According to the National Post, “History will judge President Putin as harshly as the world condemns him today,” she said. “Today, he cements his place in the ranks of the reviled European dictators who caused such carnage in the 20th century.”

Apart from sanctions, NATO has again become relevant and is flexing its military might by re-deploying troops along its’ eastern flank to deter further Russian aggression. Following a better-late-than-never philosophy, the EU members, including most notably Germany, will deliver as soon as possible stinger anti-aircraft missiles and anti-tank weaponry to Ukraine’s front lines. As it turns out, to the chagrin of Putin, NATO and the free world now seem to be holding four of a kind!


To be fair, we were surprised by the post-invasion sell-off in the equity markets. Particularly since Russian intentions were well telegraphed. That markets rebounded intra-day demonstrates that participants believed the sell-off was sentiment driven and overdone.

On the positive side, we think the February 22nd intraday lows (see chart) was a classic capitulation that represents the last leg down in the 2022 bear market.

Supporting this thesis, we cite the performance of the Nasdaq. At the low point on February 22nd, the Nasdaq 100 index had declined 21.31% from recent highs putting it clearly in bear market territory. The markets quick reversal suggested to us that sentiment propelled the early morning fallout (i.e.: uncertainty related to the start of the invasion) rather than a change in long term fundamentals. A significant market move propelled by fear or greed typically leads to sharp moves in the other direction. In this case the market experienced a sharp intraday rally that turned early losses into a positive finish.

Our view was that one of two scenarios would play out in Ukraine. Neither would benefit Russia, although it may surprise you that both scenarios would be positive for equity markets.

The first scenario had Russia overrunning Ukraine with a quick end to the war. Sanctions would remain in place for much longer and Russia would be stuck trying to rule a large country with limited resources to rebuild.

The second, which seems to be playing out, is the incursion gets bogged down exposing huge cracks in Russia’s military machine. If Ukraine can thwart the red army, one has to wonder how long Putin will be able to bluster and hold onto power.

Regardless of the outcome, Western sanctions will isolate Russia and decimate their economy. Look for Russia’s Ruble to lose 30% to 40% of its value. Sanctions will have a negative, albeit muted, impact on global business, which could spark additional waves of inflation – notably in higher prices for wheat, oil, and natural gas – all primary Russian exports.

Despite that, we believe inflation will abate over time since most of the problems are the result of friction in supply chains, which have more to do with zero-covid policies in China and the Asia Pacific basin.

Another contributing factor to inflation is the demand-driven paradigm. As G-7 economies normalize, consumers flush with strong balance sheets, are spending more. Demand is at levels not seen in more than thirty years, as witnessed by the limited supply of housing stock.

Our Investment Review Committee (IRC) notes that inflation is currently running three standard deviations above normal. It is reasonable to assume that this level of inflation will succumb to mean reversion, transitioning over time back to something like a 2.2% annual rate.

There are also concerns that sanctions will negatively impact the labour market. However, with shifting demographics and unemployment currently at fifty-year lows, we believe the underlying demand for workers should more than offset any impact from Russian sanctions.

Overall, assuming supply chains normalize, allowing product allocations to balance existing demand, inflation should moderate by the end of the year. Markets, which are a forecasting mechanism, should thereby continue to trend upward as the crisis in Ukraine unfolds.

We also suspect that the crisis in Ukraine will influence the outlook for interest rates, particularly in terms of the speed and size of interest rate adjustments. Whereas forecasters had predicted up to seven quarter point rate hikes in 2022, we think three hikes are more likely.

We are on the lower end of estimates. Over the next twenty-four months, the IRC is expecting central banks to increase rates eight times, with most hikes occurring in 2023. Market consensus has the U.S. Federal Reserve’s overnight rate hitting 2.5%, implying six rate hikes by year end. However, consensus estimates have been contracting since the onset of the Ukrainian conflict.

Based on these interest rate forecasts, we expect the spread between two-year and ten-year government bonds to compress, which should support our forecast for the S&P 500 index. Yield compression will lower long term interest rates which benefits fast growing technology companies. That being the reason the tech-heavy Nasdaq 100 index rebounded so strongly last week.

Our current outlook is also based on enhanced uncertainty. As such, we expect higher than average market volatility patterns through the remainder of the year. Fortunately, that benefits our derivative strategies as volatility-based option premiums generate greater income during volatile periods. Currently, option premiums are trading at prices 20% to 25% higher than during the last quarter of 2021.

In that environment, we anticipate option writing strategies should generate above average risk adjusted returns through the remainder of 2022. Our objective is to take advantage of this price action through our proprietary Option Writing and Alternative Strategies pools. The former provides monthly income to unit holders (payable at a rate of 6.25 cents per unit per month), while the latter’s objective is to utilize spreads that take advantage of option pricing anomalies.

As with any forecast, we continue to focus on the data. Using a model from Bloomberg, we put the fair value of the S&P 500 at 4,938. Based on the current metrics, the IRC believes that the S&P 500 composite index will end the year well above 5,000. This estimate assumes an expected price-to-earnings expansion for the period of 17.8% and an earnings per share return of 25.3%


If I could paraphrase Lawrence Block, there are eight million stories in the naked world of option strategies and the naked put write is one of them. Hard to believe such a simple concept has caused so much pain for so many investors. Unfortunately, untold horror stories have saddled the naked put strategy as being highly speculative.

A naked put, also called an “uncovered” put, is an option whose writer (the seller) does not have a position in the underlying stock. Professional investors sell naked put options to accumulate a position in the underlying stock at an acceptable price. Individual investors tend to speculate by leveraging the strategy.

When we write (i.e., sell) an uncovered put option we assume an obligation to buy the underlying stock at the strike price of the put. For example, selling an XYZ August 100 put, obligates us to buy one hundred shares of XYZ common stock at $100 per share until the August 20th, 2022, expiration.

If we assume that XYZ is currently trading at $100 per share, the XYZ 100 put would have a theoretical value of $7.50 per share based on current equity option premiums.

By selling the put, we receive $7.50 per share premium for assuming the obligation to buy shares at $100. We retain that $7.50 per share premium regardless of what happens to XYZ.

The maximum profit from the sale of a naked put option is the $7.50 per share premium received. The maximum profit occurs if the put option expires worthless because XYZ is trading above $100 at the August expiration. No one will want to sell, and so require us to buy, shares at $100 if the shares are trading at a price above that in the open market.

The downside is more dramatic. Theoretically, XYZ could decline to zero between now and August. In that case, we would have XYZ shares “put” to us at $100 when they would be worthless in the open market. Not very appealing… potentially risking $100 per share for the chance to earn a maximum $7.50 per share.

Therein lies the rub! Speculating on the movement of XYZ is one thing. Looking to acquire a position that your manager believes should be in the portfolio is quite another. Acquiring a position at a more attractive price point is a viable long term portfolio management tool. If assigned our acquisition cost would be $92.50 ($100 strike price of the put option less the $7.50 per share premium received). If that price point makes sense, then the use of a naked put option is a reasonable way to efficiently allocate portfolio resources.

This approach is not new. Financial commentators and portfolio managers often cite stocks that they would buy on a pullback. Often traders will enter “limit” orders that stipulate a price at which they will buy the shares. In that sense, selling a naked put is just another way to acquire stocks at below market prices (i.e., the strike price of the put option).

The difference is that limit orders get executed if the stock touches the pre-assigned price. The naked put is often not exercised until the expiration date. XYZ could trade below the $100 exercise price, and we may not actually end up with the shares. Only if the stock is at or below the option’s strike price at or near the August expiration are we likely to acquire the shares.

The Leverage Paradigm

How did such a basic strategy get such a bad reputation? In a word: leverage. When you enter a limit order you must have the money set aside to buy the stock. Too many investors selling naked put options, use it as a trading strategy, never expecting to own the underlying shares.

If the trader is over-leveraged, and the underlying stock price gets whacked, the put writer experiences a double whammy. The value of the put is rising because 1) the stock is declining, and 2) volatility is increasing.

Think of it this way. When a stock sells-off because of an adverse event, holders scramble to buy puts as insurance. They will usually pay any price in the same way that one would pay any price to buy fire insurance when the house is burning down.

The volatility component of the option pricing formula quantifies this rush to the exits, and factors fear into the put option’s price. Over-leveraged put writers receive unintended margin calls causing them to close their positions at exactly the wrong time.

Using naked put writing as an alternative to a limit order, means keeping sufficient capital to guarantee the obligation. If one anticipates assignment, then naked put writing is just another portfolio management tool.

As for the disparity between downside risk and upside potential, it comes down to understanding the long-term objective. We sell puts with sufficient cash or margin to buy the shares at a specific price. The stock can decline below the price we end up paying for it. But that is a function of the stock, not the option strategy. And long term, we would expect good stocks to recover.

Aside from its use as a portfolio management tool, selling naked puts on U.S. stocks can be an attractive tax strategy. The option premium accounts for any dividends paid by the underlying company. Canada classifies income from selling puts as capital gains, but counts U.S. dividends as ordinary income in non-registered accounts.

Interestingly, the option pricing formula includes an input for dividends. When we sell an option, we receive the equivalent of the underlying dividend taxed as a capital gain in non-registered accounts. That is particularly useful within our pools that operate under a corporate class structure.

Selling a put option to accumulate a position in the underlying shares is not that different from a limit order where investors attempt to accumulate a stock position at a set price. If the stock reaches the pre-assigned price, it triggers the limit order, if not the limit order expires.

Same with the sale of a naked put. If the stock does not decline to the exercise price of the put option, it will expire. We retain the premium which one could say is a gift for “playing the game!”

Richard Croft, Chairman & CIO

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