New Trade FXI – Hang Seng, Dude

by Enis July 30, 2012 12:46 pm • Commentary

The Shanghai composite closed at a 3 year low last night.  At the lowest level since March 2009.  Multinational after multinational pointed out the weakness in Asia, and Chinese investors seem to agree with that weakness.  They won’t buy Chinese stocks even when global markets ramp.

Chinese-driven growth seems to have serious issues.  Here is a chart from FtAlphaville last week showing what has happened to steel prices in China (by way of Nomura research):

 

 

 

Since so much of Chinese growth is driven by fixed-asset investment (generally infrastructure focused), steel prices have been a pretty good indicator for Chinese growth in general.  Stocks tied to the commodity and infrastructure story in China have been hit particularly hard this year as a result (coal names, steel names, CAT, etc.).  Not surprisingly, energy (XLE) and materials (XLB) are the worst performing major sectors in the U.S. markets this year.

However, the Shanghai stock market is a closed, niche market (essentially closed to most foreign investors).  Even though the Shanghai composite hit 3 year lows last night, the more international, investable Hang Seng Index (Hong Kong-based) is trading more than 15% above its Oct 2011 lows.

 

 

The Hang Seng is more correlated to global markets since international investors are involved.  But the divergence between the 2 indices gives me one major takeaway:  Chinese investors have much less faith in China than international investors.  I am siding with the insiders on this trade.

FXI is the ETF that closely tracks the Hang Seng index.  When I pulled up FXI options this morning, I was most surprised by how cheap volatility was priced.  I would have thought that even though global markets seem stable, FXI options would be more expensive based on the price action in Shanghai.  Evidently not.  FXI implied volatility in September is around 25, while 10, 30, and 100 day realized volatility is all above 25.  And that’s been while FXI has basically traded in a tight range of 32 to 34 over the last 2 months:

 

 

I want to play for a move back to the $32 level over the next couple weeks, and I’m going to use cheap September options to do it:

 

TRADE: FXI ($34.00) Bought the Sept 32 / 30 Put Spread for $0.33
  • Bought 1 Sept 32 Put for 0.59
  • Sold 1 Sept 30 Put at .26

Break-Even on Sept Expiration:

Profits btwn 31.67 and 30, make up to 1.67, max gain of 1.67 at 30 or below.

Losses of up to 0.33 btwn 31.67 and 32, max loss of 0.33 at 32 or above.

 

Trade Rationale:

Cheap FXI vol offers a good way to play for a move lower.  I used Sept since so much of my current premium is concentrated in August.  Also, with volatility cheap, it makes sense to move farther out in maturity to take better advantage of lower overall premiums.  I plan on exiting the trade if FXI retests $32, but this is a much better risk/reward way to play it than to outright short FXI here.