The War Premium: How Conflicts Drive Option Prices and Volatility Index (VIX) Spikes

The Psychology of Panic: Why Wars Trigger Market Volatility

This article explores how behavioral finance shapes investor and trader decisions during geopolitical conflicts, focusing on the stock market during the Russia-Ukraine war. Behavioral finance examines how human emotions and psychological biases influence financial choices across markets stocks, bonds, derivatives, commodities, currencies, and real estate. It challenges the traditional view of purely rational decision-making by highlighting how fear and uncertainty can disrupt rational thinking. Warren Buffett’s quote, “Be fearful when others are greedy and greedy when others are fearful,” points to this paradox. In practice, fear often dominates during crises, leading to panic selling or overly cautious strategies. The rapid rise of trading in derivatives like options and futures has added another layer to this. Options, for instance, act like insurance giving the right but not the obligation to buy or sell assets for a small premium instead of paying the full price upfront. While meant to hedge risks, these tools can magnify emotional reactions during market turmoil.

Investor and trader biases generally fall into two categories: cognitive biases and emotional biases. Examples include:

• Availability bias: Giving too much weight to recent news or dramatic events.

• Cognitive dissonance: Ignoring evidence that contradicts existing beliefs.

• Framing effect: Responding differently based on how information is presented.

• Loss aversion: Fearing losses more than valuing similar gains.

• Status quo bias: Sticking to familiar choices despite changing markets.

• Overconfidence bias: Overestimating one’s ability to predict outcomes.

• Herd bias: Following the crowd in uncertain times.

• Anchoring bias: Being influenced too heavily by initial information.

  
  

These biases reveal why the Efficient Market Hypothesis (EMH) which assumes all information is reflected rationally in asset prices often fails in real life. Emotional reactions and irrational trades lead to price swings and misvaluations, especially during conflicts.

Traders can also face trading frustration when outcomes don’t meet expectations, and hidden aspects of personality combined with stress can cause emotional self-destruction like overtrading or abandoning strategies.

Recognizing these behavioral patterns can help investors and traders make calmer, more informed choices, even when fear dominates the market.

Uncertainty often leads to increased demand for protective options. A protective put is a widely used risk management strategy where a trader remains bullish on the underlying position but buys a put option to guard against unexpected downside risk. This hedge helps protect the bullish trade from significant losses, as potential drawdowns in the underlying asset can be offset by gains from the put option. The time series chart illustrates this relationship between the World Uncertainty Index (WUI) and put option volume on the CBOE from late 2020 to the end of 2024. Periods of elevated global uncertainty generally correspond with higher put volumes, reflecting investors’ tendency to hedge against unforeseen risks. However, the correlation is not perfectly positive across the entire period; there are intervals, notably around early 2023 and mid-2024, where the two series diverge. This suggests that traders’ hedging behaviors are shaped by a broader set of factors beyond uncertainty alone, such as market sentiment, liquidity conditions, and evolving macroeconomic expectations.

Implied Volatility vs Realized Volatility in Wartime

During times of geopolitical conflict, a striking divergence often emerges between implied volatility (IV) and realized volatility (RV). While RV reflects the actual historical price fluctuations of an asset, IV captures the market’s expectations of future volatility, inferred from current option prices. In wartime, fear and uncertainty spike suddenly, well before their actual economic impacts fully materialize leading to a surge in demand for options as hedging instruments. This fear-driven demand inflates implied volatility disproportionately compared to realized movements. Investors rush to buy protection, bidding up option prices and pushing IV sharply higher, even though underlying assets may not yet have shown significant turbulence. Realized volatility, on the other hand, tends to rise more gradually as the fundamental consequences of the conflict such as supply chain disruptions, inflationary pressures, or sanctions begin to play out. This creates a pronounced volatility risk premium, the gap between IV and RV which essentially reflects the price investors are willing to pay for perceived safety. The VIX, often dubbed the "fear index," exemplifies this behavior, frequently overshooting during global conflicts as markets brace for worst-case scenarios that may never fully unfold.

Empirical Illustration (Oil Options, Iran–Israel Conflict)

In early May 2025, 1‑month WTI oil option IV jumped over 20 percentage points to ~51% amid Iran–Israel hostilities, reaching a three‑year high. Over the same period, oil’s 30‑day RV rose by only ~10 points. The resulting volatility risk premium (IV–RV) for oil exceeded 16 points, making it the richest across major asset classes.

Equity Markets and the VIX

The VIX (30‑day SPX IV index) frequently “overshoots” during conflicts. For example, when the Russia‑Ukraine war intensified in February 2022, the VIX leapt from ~25 to over 40 within days, whereas the S&P 500’s realized volatility rose from ~20 to ~30, leaving a dramatically wider IV–RV gap.This disproportionate IV inflation embodies the “war premium,” reflecting both genuine uncertainty and the extra cost of insuring against extreme tail events.

The Role of the VIX as a 'Geopolitical Risk Barometer'

The VIX, often called the market’s “fear gauge,” serves as a real-time geopolitical risk barometer by capturing investors’ collective expectations of future volatility in response to breaking news and conflict escalation. As highlighted in historical patterns, the VIX tends to surge sharply during unexpected geopolitical shocks such as the Gulf War (1990), Kosovo War (1998), the 9/11 attacks, the Georgian War (2008), the Crimea crisis (2014), and most recently, the Russia Ukraine conflict as market participants scramble to hedge against potential downside risks. This behavior is driven by implied volatility, which reflects real-time market sentiment about how much prices may swing in the near future. Elevated VIX levels often translate into higher option premiums as fear permeates trading strategies.

However, as observed in the accompanying chart that tracks VIX movements (yellow line) alongside the MSCI ACWI Index (blue line) during these conflicts, these volatility spikes typically revert to historical averages once tensions stabilize and markets adjust, underscoring the mean-reverting nature of volatility. Notably, whether elevated volatility sustains depends on whether the geopolitical event is a short-lived shock or evolves into an entrenched, prolonged conflict. Prolonged conflicts can keep volatility and risk premiums higher for longer, fueled by persistent fear of market correction or an extended bear market. This persistent “war premium” extends beyond markets, reflecting broader societal and environmental costs of conflict from resource depletion and ecological damage to displacement which challenge long-term sustainability efforts. Together, these dynamics illustrate how the VIX provides a forward-looking, sentiment-driven signal of geopolitical risk, yet also how investor psychology, market adaptation, and the underlying nature of the conflict shape the sustainability of elevated volatility.

Options Market Reaction to the Outbreak of War

When war breaks out, the options market reacts almost instantaneously as traders and institutions scramble to hedge uncertainties. One of the clearest early indicators is the put‑call ratio, the number of put options traded relative to calls. In the immediate wake of conflict, this ratio typically spikes well above its long-term average (~0.7 for equities), often crossing 1.0 or higher, signaling a rush toward downside protection.  Concurrently, option premiums soar, as implied volatility surges, option buyers are effectively paying more to insure portfolios or speculate on spikes. Volume also spikes dramatically; for instance, during June 2025 Middle East tensions, a staggering 33,411 WTI crude oil $80 call contracts were traded in a single day, nearly double the January figure of 17,030 within a total volume of 681,000 contracts, underscoring how oil traders aggressively speculated on a supply shock. Behind the scenes, market makers adjust hedging positions rapidly, leading to wide bid‑ask spreads and elevated premiums even before time decay and fundamental data adjust. This torrent of activity reveals a pronounced shift in market sentiment, safe‑haven demand overwhelms normal trading patterns, and hedging becomes the dominant playbook.

Sectoral Divergence in Option Pricing During Conflicts

During geopolitical conflicts, option pricing diverges significantly across sectors due to differences in perceived risk exposure and market sentiment. According to the option pricing framework, option value is influenced by key components: the underlying asset price, strike price, time to expiration, volatility, and interest rates. Each of these variables reacts differently during conflicts, especially across sectors. For instance, defense stocks often become call-heavy as investors anticipate higher government spending and stronger earnings, driving up demand for call options. Conversely, travel and airline stocks typically become put-heavy, reflecting expectations of operational disruptions, reduced demand, and higher fuel costs due to rerouted flights and geopolitical tension.

The put–call ratio (PCR) data from February 2022 the month when the Russia Ukraine war began illustrates this sectoral divergence within the Indian market. As seen in the table, defense and energy companies like BHEL and ONGC show relatively low PCRs of 0.37 and 0.14 respectively, indicating stronger demand for calls as investors speculated on potential gains from increased defense contracts and stable domestic oil production. Notably, India's relative self-reliance in oil production insulated its energy sector from extreme downside risk, helping maintain a low PCR. On the other hand, airlines such as IndiGo reported a higher PCR of 0.68, as geopolitical tensions directly affect international travel demand, force route changes, and increase operational inefficiencies  prompting investors to hedge with puts. Similarly, Tata Motors (with a PCR of 0.47) and Coal India (PCR 0.37) also saw moderate demand, as automotive and utility sectors may experience mixed impacts from rising input costs and potential policy shifts.

In summary, option pricing reflects market expectations shaped by sector-specific exposure to conflict risk. Defense and energy sectors often attract call-heavy positioning due to anticipated government spending and domestic production stability, while travel and consumer-driven sectors become put-heavy as geopolitical tensions disrupt demand and supply chains. This divergence in PCR ratios during February 2022 effectively captures how investor sentiment varies across industries in response to geopolitical shocks underscoring the nuanced role of sectoral fundamentals within the broader option pricing model.

Hedging vs Speculating: Dual Roles of Options in Wartime

Options play two distinct roles during wartime, hedging and speculating with traders and investors often needing to navigate the fine line between protection and opportunism. On the hedging side, institutional and retail investors flock to put options or VIX-linked products as threats loom. For instance, following recent trade‑war tensions, demand for S&P 500 hedges surged, with VIX‑call purchases by institutional players and retail “tail‑hedge” strategies driving premiums to record levels. Meanwhile, on the speculative front, volatility traders seize opportunities created by the panic-driven spikes in the VIX. As the VIX soared above 40–50 in April 2025, options strategist Jermal Chandler initiated purchases of VIX‑based put options, profiting as futures retreated to ~24. Similarly, traders like Kevin Kwan ride the mean‑reversion wave by shorting the VIX post-spike, betting that panic subsides faster than it emerged.

These dual roles reflect a broader volatility-arbitrage strategy: hedgers buy insurance, driving IV higher, while speculators build delta-neutral positions to sell or profit from volatility normalization. Yet this approach is not without risk. Volatility products often suffer roll‑decay, and timing is critical, misjudged positions can lead to outsized losses, as seen in recent short‑volatility blow ups where traders lost billions.

In essence, wartime option markets become a crucible where safety needs and speculative instincts collide: protective hedging inflates implied volatility, even as volatility traders bet on its eventual decline. The result is a dynamic landscape in which both behaviors fuel each other, hedgers pushing prices up and speculators seeking to profit when the panic fades.

Geopolitical Risk Index vs VIX: Tracking Two Measures of Global Fear

The Geopolitical Risk (GPR) Index, developed by Caldara & Iacoviello, offers a systematic way to quantify global geopolitical risk by tracking the frequency of newspaper articles referencing geopolitical tensions, war threats, and terrorist events. As shown in the accompanying chart, the GPR index (blue line) and the VIX (red line) often rise together during major geopolitical crises  such as the September 11 attacks, the Iraq War, the Global Financial Crisis, Russia’s annexation of Crimea, the US China trade tensions, the COVID-19 pandemic, and most recently, the invasion of Ukraine. Both indices serve as forward-looking measures of market sentiment and uncertainty, yet their movements are not perfectly synchronized. The VIX, derived from implied volatility of S&P 500 options, reacts swiftly to financial market stress and immediate hedging demand, whereas the GPR index reflects broader geopolitical discourse and sustained public concern, which can remain elevated even after markets stabilize. Notably, while the VIX does respond to certain geopolitical events like the September 11 attacks, the US Iran tensions, and the invasion of Ukraine, its spikes are often more pronounced during major economic crises such as the Global Financial Crisis and the COVID-19 shock highlighting that market-based volatility responds more strongly to financial stress than to geopolitical narratives alone. The correlation between the VIX and GPR is calculated at just 0.026, indicating a very low relationship between the two; this suggests that while each captures a dimension of market risk, they reflect fundamentally different forces and are not directly correlated.

Empirical evidence shows that rising GPR can significantly amplify stock market volatility, particularly in emerging economies, crude oil exporting countries, and countries at peace. Geopolitical shocks undermine mutual trust, disrupt global supply chains, and increase perceived investment risk, prompting investors to delay consumption and firms to postpone capital expenditures (Bloom, 2009). For crude oil exporters, geopolitical risk often translates into sharper market swings due to the sector’s sensitivity to global political developments. Interestingly, the impact of GPR is found to be greater on stock market volatility in countries at peace than in those already engaged in conflict, as unexpected shocks trigger stronger market reactions where risk was previously perceived to be lower. Furthermore, PwC’s Global Investor Survey (2018) confirms that institutional investors now consider geopolitical risk to be a critical determinant in investment decisions.

Taken together, these insights underscore why policymakers seeking financial market stability should closely monitor and address geopolitical risk, and why investors should incorporate GPR into their risk management frameworks especially when analyzing markets in emerging economies, resource-dependent countries, and relatively peaceful regions. The interplay between the GPR index and the VIX ultimately illustrates how geopolitical narratives and investor psychology collectively shape market volatility: sometimes moving together, and at other times diverging, as markets adjust or become temporarily desensitized to prolonged geopolitical uncertainty.

Source- MSCI

Options Trading Around Key War Events and Announcements

1. Pre-Invasion Build-Up In the lead-up to major conflicts, implied volatility (IV) often rises quietly but significantly. Before Russia invaded Ukraine in February 2022, the VIX climbed from ~17 in early January to over 30 by mid-February, a near 76% increase even before a single troop crossed the border. Similarly, crude oil option IV rose by more than 10 percentage points in the week leading up to June 2025’s Iran-Israel escalation. The put–call ratio for S&P 500 options also inched above 0.9, reflecting a subtle but steady shift toward protective hedging.

2. Day of Invasion or Strike On the day a war breaks out, volatility and option activity explode. When Russia invaded Ukraine on February 24, 2022, the VIX spiked to 37, its highest level in over a year, while S&P 500 put volume surged over 150% above the 30-day average. Similarly, in June 2025, amid the Iran–Israel strikes, over 33,000 WTI crude oil $80 call options were traded in one day, almost double the volume seen a few months prior.

3. Immediate Aftermath (1–7 Days Post-Event) In the days following conflict outbreaks, realized volatility (RV) begins to catch up, but the IV–RV gap often remains wide. After the Russia–Ukraine invasion, S&P 500 30-day realized volatility rose from ~17 to ~30, while IV hovered near 35–40, sustaining a volatility risk premium of over 5–10 points. In June 2025, oil’s realized volatility climbed by about 10 points, compared to a 20-point surge in implied volatility. Bid–ask spreads in commodity and equity options widened by up to 30%, reflecting pricing stress and uncertainty.

4. Ceasefires and De-escalation Following announcements of diplomatic breakthroughs or ceasefires, the options market rapidly cools. On June 24, 2025, after reports of an Israel–Iran ceasefire emerged, the VIX dropped from 32 to 26 in a single day an 18% plunge, its sharpest daily decline in over a year (WSJ). Put–call ratios eased back below 0.7, and option volumes in major indices normalized within days. This sudden drop reflects the market’s tendency to price in extreme scenarios, then unwind risk aggressively once clarity returns.

Long-Term War vs Short-Term Shock: The Sustainability of the War Premium

Periods of geopolitical shocks and prolonged conflicts typically cause option prices and volatility indices like the VIX to spike sharply, as investors react to heightened uncertainty and the perceived risk of deeper market corrections. The VIX often moves exponentially upwards during such periods, reflecting the surge in demand for protective options driven by fear and behavioral biases. However, these elevated levels generally revert back to their historical mean once tensions ease or markets adjust, since volatility is widely regarded as a mean-reverting phenomenon. The sustainability of elevated VIX levels largely depends on whether the conflict is a short-lived shock or evolves into an entrenched, protracted war; entrenched conflicts tend to keep volatility and risk premiums higher for longer, as investors continue to price in prolonged geopolitical risk.

This persistent risk premium sometimes described as a “war premium” extends beyond financial markets, encompassing hidden environmental and societal costs such as resource depletion, long-term ecological harm, displacement, and broader disruptions to sustainable development. From a market perspective, option pricing is deeply influenced by volatility, which measures the extent and speed of price fluctuations of the underlying asset. Implied volatility (IV), reflecting market participants’ real-time expectations of future price movements, typically rises when markets trend downward as uncertainty mounts, pushing option premiums higher. Conversely, market recoveries and stabilization often lead to a decline in IV. Historical volatility (HV), by contrast, tracks past price movements over defined periods and serves as an anchor, with the idea that observed volatility eventually gravitates toward a long-run average determined by fundamental factors. Together, these dynamics illustrate why option prices surge during geopolitical crises and why volatility often tapers off as markets gradually adapt to new realities unless persistent fears of a sustained downturn keep volatility uncharacteristically high.

Lessons from History: What Past Conflicts Tell Us About Today’s Option Markets

Throughout modern financial history, major geopolitical conflicts, from World War II to the Gulf War and Cold War brinkmanship, have left clear imprints on options markets and volatility dynamics. During WWII, stock market volatility surged in 1939 but then steadily eased through the 1940s as industrial production stabilized. Paradoxically, researchers note that, due to consistent defense spending, realized stock volatility was roughly 25% lower during wartime, a phenomenon known as the “war puzzle”. In the Gulf War of 1990–91, oil futures and options experienced sharp IV spikes, while prices normalized shortly after the conflict ended.

Fast-forward to the present: today’s option markets, driven by algorithmic and high-frequency trading, respond within microseconds. Algorithms detect macro news and implied volatility distortions almost instantaneously, executing trades that exaggerate short-term volatility spikes, much like the VIX surges triggered by AI-based trading signals. This is a far cry from the pre-electronic era, when human traders would gradually digest international headlines before acting. Now, a single war-related tweet or automated newsfeed can trigger a flash crash–style vol event, amplifying and accelerating volatility shifts far beyond past norms .

In essence, while historical conflicts illustrate that volatility does rise, but sometimes unexpectedly muted in realized terms, the speed and intensity of today’s volatility reactions are unparalleled. The interplay of historical patterns with modern algorithmic amplification offers a compelling backdrop to today’s war premiums and VIX dynamics.

References-

NSE India

Investopedia

Science Direct

nber organisation

WSJ

AUTHORS-

Nandani | LinkedIn

Aryan Prajapati | LinkedIn