Name That Trade – $EEM: Emerging Volatility?

by Dan January 3, 2014 2:50 pm • Commentary

EEM (the ETF that tracks emerging markets) is down 4% already this year, largely a continuation of poor sentiment relative to the strength of China’s recovery after a worse than expected non-manufacturing PMI print yesterday coupled with rumors that Samsung (largest EEM component at 3.6%) will miss sales estimates when they give preliminary Q4 results on Jan 7th, not to mention the upheaval in Turkey and the wild fluctuations in the Lira and in their equity markets.

As I mentioned in the MorningWord earlier:

it would be complacent of investors not to keep an eye on the damage done in emerging markets the last couple days with Brazil and China down a bit more than 1.5% and the ETFs that track these markets (EEM, EWZ & FXI) all down more than 3% in yesterday’s trade.  While China’s weak non-manufacturing PMI data will be cited (lowest reading since August), from where I am sitting EM and the potential for reflation of growth is the single largest risk to the rally in the developed world.  While bulls point to the stabilization and the lack of hard landing, if we are to see a correction in 2014, a stagnation or a mild decline in growth would likely be the stumbling block.

At $40, EEM is right at the middle of the 9 month rangrangee of about $36 (green line) on the downside and $40 (red line) on the upside.   The etf is in no mans land from a technical perspective, but there are some troubling technical signs emerging: 

EEM 1 yr Chart from Bloomberg
EEM 1 yr Chart from Bloomberg

The stock is sitting on an interesting intermediate support level at $40 (white line) and just broke two key momentum indicators to the downside, the 50 day (purple line) and the 200 day (yellow) moving averages this week alone, both of which were declining.

My sense is that a slow down in China or some percolating issues in the emerging world could be the one thing to side track the equity strength in developed markets, IF you are long and strong US equities and agree that EM could be the one wrinkle to continued equity gains in the developed world, then look at EEM puts, as implied vol is relatively cheap, well below the flare ups of the last 2 years:EEM 2 yr at the money Implied Vol from Bloomberg

EEM 2 yr at the money Implied Vol from Bloomberg
Hypothetical Trade:  EEM ($40.10) Buy Feb 40 for 1.15

-Buy 1 feb 40 put for 1.15

Break-Even on Feb Exp:
Profits: below 38.85
Losses: up to 1.15 btwn 38.85 and 40 and all 1.15 above 40 or 3% of underlying.

Trade Rationale: This is the type of trade that you would want to put on if you want to stay long equities but have that worry that if things go wrong to start 2014, it most likely will be from the emerging markets first. This is the type of trade that you could spread, on further weakness by selling the 35 puts. This ETF will move quickly and it should be thought of as a portfolio hedge, especially if you are getting a little nervous here. As far as a straight up trade, again, it’s in the middle of its range so it may not be the best entry ever, but we wanted to bring the ETF and how to play to everyone’s attention. We’ll be keeping our eye on this one.