On Sunday night, as Chinese equity markets were getting ready to open following the government’s unprecedented moves to stem declines, my focus was on where the Shanghai Composite needed to hold:
Shanghai Comp’s 200 day moving avg is very near the March breakout level near 3400, would be 34% decline from highs pic.twitter.com/wDyA2aTIva
— Dan Nathan (@RiskReversal) July 6, 2015
With out going full play by play, the early week downward volatility in Chinese stocks was met with late week upward volatility, with the Shanghai Composite closing up 5% after at one point being down 15% from Monday’s highs.
This morning (MorningWord 7/10/15: $SPX – Running to Stand Still), I concluded that despite the apparent test and hold of support:
A short of the Shanghai when this rally appears to be faltering, playing for a break of 3400 could be the trade of the year, cause when it breaks the next time, after all the crap the government has pulled, it ain’t gonna be pretty.
So how do I plan to set up for this trade? There are two very liquid etf trading vehicles that U.S. investors can express directional views. The first, FXI, is made up of Chinese H-Shares listed in Hong Kong. The second, ASHR, is made up of mainland listed stocks listed in Shanghai (ASHR) which tracks A-Shares, the CSI 300 Index, and is closely correlated to the Shanghai Composite (read more here). I like using the ASHR as it is my belief that despite options prices being much higher than those of FXI, that’s where you are gonna get the most bang for your buck in another panic.
So how to play?
Short Dated Puts: Outright options purchases are nuts. For instance if your were looking for a pullback in ASHR next week, the July 17th 43 put (stock price $43.15) is offered at $2.25, which means you would need a move below $40.75 to just break-even, down 5%. Which doesn’t seem crazy when you consider the etf was up 20% yesterday alone, but if the market was to settle, or rally, the premium in those short data puts would get destroyed quickly as implied volatility comes in.
Long Dated Puts: If you thought getting the short term timing correct on a re-test of last weeks lows was a fools errand, but you are fairly well convicted that it will happen at some point in the next few months, you run the risk of buying long dated options at extremely high prices in volatility terms. This could be a disaster for long dated options holders if the market started to creep, or go higher as 30 day at the money IV would likely come in 30 points at least:
[caption id="attachment_55230" align="aligncenter" width="600"]
AASHR 1yr chart of 30 day at the money IV from Bloomberg[/caption]
For instance the October 43 puts (stock ref $43.15) are offered at $6, which break-even at $37, down 14%. Again you could say the etf was just there, but if the move back there happened slowly, it would be a very painful event for your PnL.
Short Call Spreads: When vol is so high, and outright purchases look extremely expensive, then why not sell calls or call spreads to make a bearish bet. Well, outright call sales are nuts. Who knows how high the market can go under the best case. So selling call spreads could make sense, but they are just not that attractive as the option you need to buy to define your risk is amazingly expensive in both vol and dollar terms. For instance, the July 17th 45 /47 Call spread (stock ref $43.15) can be sold at 55 cents. That risks 1.45 to make 55 cents if the stock is below $45. That would kind of be a chicken-shit way to short the stock, and not great risk reward on the defined risk. You could widen the spread out but the July 45/50 call spread is less than $1 which is even worse risk/reward.
So…..
Long Call Spreads?? I was discussing this conundrum with a smart options trader friend of mine and he said “well if call spreads look like such a bad sale then they are probably a good buy”. I hear that, I am just not buying into what I believe is a mania that will end very badly regardless of the price action in the coming days.
Which leads me to trying to figure out how to be long puts for a re-test of technical support, but offset what could be brutal decay in long premium strategies.
Long Diagonal Put Calendars: The trade that I am considering is buying Longer dated at the money puts, and financing by selling short dated downside puts. This way I reduce my premium outlay, and I keep doing the roll of the short strike a week out as they expire worthless. Ultimately the idea would be to turn into a vertical spread. For instance, with the ASHR at $43.20, I could sell the July 17th 39 put at 75 cents and buy the Aug 43 put for 4.70. The trade costs 3.95 and offers potential for a number of outcomes over the next week. The ideal scenario is that the stock would move lover between now and next Friday, but above $39 and I roll down the short strike to another weekly, after watching the Aug 43 put appreciate quite quickly.
The issue with this strategy is owning that high implied volatility out in August. You really need to get the timing and direction correct because if you saw a slow creep higher in the ETF the implied volatility in your long puts would get crushed.
This is obviously quite complicated then. Both the price action in the underlying, and the way to play with options.
For those who are long these etfs playing for a bounce, the idea of selling calls against your long stock is very attractive given how high options premiums are. That’s one that make sense.
We are gonna give this trade another day, I would love to see another 10% early next week.