Trade Idea – $EEM: Emerging Volatility?

by Dan November 6, 2015 2:40 pm • Commentary

In today’s MorningWord (Bulls in China Shop) we looked at China’s bear market rally (since the Aug lows) and tried to determine what is says about the health of their economy, and what it means for global equities, specifically U.S. stocks. Here’s a taste:

EEM 5yr chart from Bloomberg
EEM 5yr chart from Bloomberg

So how does this help you make money here in the U.S.? Simple, on the way up in the first half of 2015, the Shanghai’s inflated stock market bubble did not help U.S. stocks as they remained in a fairly tight trading range, straddling unchanged for the year. Until August, immediately following the surprise yuan deval, when fears of bubble bursting, both economic and stock market, devastated global risk assets. Since August 24th, most equity markets have risen at least 10%, crude oil has risen 20%, the US Dollar (DXY) has risen 7% and US Treasury yields have risen 30 bps.

So bringing it back to China, and their equity “bull market” none of the above is really good for their economy and their recent stock market rally could come to a screeching halt if the FOMC were to raise interest rates in December. And the US stock market could get in front of it, as it appears to be doing today after the HOT US jobs data.

Higher US rates, means higher US dollar, which could mean pain for emerging market economies like China whose economy is fragile at best. And for those that are convinced that Q3 results from Apple, Nike & Starbucks show that, despite 6.9% GDP growth, China’s economy is just fine? Those same three brands are doing great in the U.S. as well, where overall retail sales and consumer confidence (despite the Oct Jobs data) is less than fine. Those Q3 results from three of the biggest brands in the world look more and more like an anomaly.

But what’s the trade?? Simple, short Emerging Market equities into what seems like a foregone conclusion that the FOMC will raise the Fed Funds rate for the first time in nine years.

To express this view I want to look at the EEM, the emerging market etf which was recently rejected at very important near term technical resistance of $36:

EEM ytd chart from Bloomberg
EEM ytd chart from Bloomberg

The $36 level is also a massive long term technical support / resistance level dating back to ten years, most recently very important support until August’s break below:

EEM 10 yr chart from Blomberg
EEM 10 yr chart from Bloomberg

Despite today’s knee-jerk move lower in the etf after the jobs data, and the subsequent uptick in vol, short dated options prices look reasonable for those looking to make directional bets, with 30 day at the money vol just below 21%, vs 30 day realized vol at 22.50% and 90 day 27%.  If you are of the mindset that the fear of a rate hike at the Dec 16th Fed meeting could cause emerging market stocks to retest last month’s lows, then long premium options trades in the EEM could make sense:

EEM 1yr chart of 30 day at the money IV from Bloomberg
EEM 1yr chart of 30 day at the money IV from Bloomberg

SO here is the trade:

Trade: *EEM ($35.30) Buy Dec 35 / 32 Put Spread for 70 cents

-Buy to open 1 Dec 35 put for 90 cents

-Sell to open 1 Dec 32 put at 20 cents

Break-Even on Dec Expiration:

Profits: Gains of up to 2.30 between 34.30 and 32 with max gain of 2.30 ar 32, down 9%

Losses: up to 70 cents between 34.30 and 35, with max loss of 70 cents, or 2% of the etf price above 35

Rationale:  EM stocks and EM currencies should be the first thing hit on a US rate increase, if we get one. Options in EEM are relatively cheap, and this spread offers a break-even down 3%, with a max potential profit down 9% of 3x the premium at risk. Given the upcoming event, I like the risk reward of this trade.