China Raising Rates….Again. Way To Play Potential For Near Term Pull Back in FXI.

by Dan April 5, 2011 7:33 am • Commentary

Wow, They Are Practically Throwing The Kitchen Sink At This Thing…….Last night China announced (read here) that they are raising their one year lending rate and their one year deposit rate by 25 bps, again for the 4th time in a little over a year.

-Seems like everyone in the world, excluding our fed is worried about inflation, and we are obviously likely to see a continued trend towards tighter monetary policies globally as commodity prices continue their surge and food reserves remain strained.

-But don’t you worry if history tells us anything over here, our fed is very likely to keep rates at zero (or below) just long enough so you can go buy that second home that you don’t need, and the stock market gets REALLY “artificially” inflated.

Moving on.  China.

TECHNICALS: Shanghai Composite has had its fits and starts over the last year as the tightening by the Government was also aimed at cooling down a stock market that seemed to be on a path to overheating in 2009.  Four year chart below shows the index sort of flat-ling for the last year and half since China started contemplating tightening.

Shanghai Comp 4 yr chart By Bloomberg

Chart below shows the Shanghai Composite vs the S&P500 over the last year, clearly showing China under-performance in the last 6 months as we have been easing and then have been tightening.

Shanghai Comp vs S&P 1 yr by Bloomberg

MY VIEW: While I am certainly not an economist, I do fancy myself to be a bit of a chartist.  While it is not easy to trade the Shanghai Comp, most traders in the U.S. focus on the actively traded FXI, iShares FTSE China 25 ETF.  I am looking for not only a SPX pullback in the next month or so, but one in emerging markets too. Chart of the FXI below shows a a nice little breakout to new 5 month highs.  In the face of the latest round of monetary tightening I would look for a little consolidation of this range back towards $44.

FXI 7 Month Chart by Bloomberg

TRADE:  FXI (46.35 ref) BUY the MAY 46 / 44 / 43  Put Tree for ~.25

-Buy 1 May 46 Put for ~1.25

-Sell 1 May 44 Put at ~.60

-Sell 1 May 43 Put at ~.40

Break-Even on May Expiration:

Upside: btwn 45.75 and 46 you lose .25 premium you paid for structure, above 46 you lose all .25

Downside: btwn 45.75 and 44 you can make up to 1.75, MAX PROFIT at 44 (down 5%), btwn 44 and 43 you make all 1.75, but the Worst Case is that the stock is at or below 43 (down ~7.25%) and you are Put the stock at $43 and you 1.75 gain starts to trail off

TRADE RATIONALE: this trade structure is not for everyone and if you agree that China can pull back a bit and want to play, but want to define your risk you can just buy a put spread so you are not NAKED short a Put.  I like this Structure because I am not outlaying a lot of premium to make a bet that the index will be down 5% ($44 in the FXI) and can make multiples of the premium outlay if that occurs.  I think a 7% ($43 the level you are short the extra Put) move lower in the next month, while certainly possible is not that likely barring some big unforeseen geopolitical event.  Remember that the SPX only sold off 7% from multi year highs after the disaster in Japan.  Also I have created a level where I am willing to draw a line in the sand about how far the ETF will sell off, thus the reason for creating the ratio spread.  I am not selling more puts than I am buying because i think there is an opportunity to sell some expensive VOL, because it is not, I am merely do it to lessen the price of the spread……One Alternative to the TREE would be too initiate the May 46/44 Put Spread and then wait till the thing starts working and then lock in some gains by then selling a lower strike Put, thus completing the Put Tree.