On November 6th we placed a defined risk bearish trade in the emerging markets etf EEM. Here were our thoughts at the time and the trade:
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:
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
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.
It looks like we will see that Dec rate increase and EEM has trended lower since our entry. But it’s not just a potential US rate increase having an effect. There have been some headlines out of Brazil of late that have emerging market investors a but spooked, and possibly signalling the third wave of the rolling financial crisis that started here in US in 2007/08, moved to Europe in 2010/11 and is now hitting emerging markets like Brazil and China. It’s about deleveraging. We are far along in the U.S., and investors seem comfortable with Europe’s pace, but the BTG Pactual situation last week, related to corruption nearing the highest levels of their government, and once the largest company, Petrobras in their country, intensifies the potential for some sort of systemic credit risk related to the commodity complex:
Widely regarded as one of Brazil’s most-talented bankers, the 47-year-old billionaire’s involvement for the first time raises the “earnest prospect of financial contagion,” political consulting firm Eurasia Group said. BTG clients withdrew 4.2 billion reais ($1.1 billion) from some of the bank’s most-liquid fixed-income funds on Nov. 25-26, data on the securities regulator’s website shows.
And Petrobas’ problems aren’t going away:
The debt clock is ticking down at Brazil’s troubled oil giant, Petrobras. Next up: $24 billion of repayments over 24 months.
That’s a towering hurdle for a company that hasn’t generated free cash flow for eight years and whose borrowing rates are soaring. Annual debt servicing costs have doubled to 20.3 billion reais ($5.4 billion) in the past three years.
So Brazil’s problems continue to weigh on EEM as a whole and could be another canary in the coalmine. With EEM at $33.90 our trade is a winner, worth about 1.20 (paid 70 cents). But it has the potential to be worth up to $3 if the decline continues. Right now EEM is threatening a move back to its September lows but if it holds here we’ll likely look to take off for small profit. The year to date chart below shows the little wedge the stock is forming, now sitting right on the uptrend from the August and September lows. We will use the downtrend from the recent highs near $35 as stop on the up side:
But, the recent decline in Chinese stocks, weakness in Brazilian equity markets and uncertainty about their governments ability to put in place economic reform, and the Fed’s impending rate decision, we like the chances of a test of the low end of the range rather than the high end in the coming weeks.