Trading the UltraShort China Hedge

In the last four months, the daily trading range of the Proshares UltraShort China ETF (FXP) has narrowed considerably against that of the IShares China ETF (FXI) using the Average True Range indicator for comparison. Average True Range (ATR) calculates combinations of price range values and applies a smoothing mechanism (we used a 21 day average) to raw true range. It gives a good measure of volatility.

The FXP (double inverse of FTSE/Xinhua China 25 index) and the FXI (tracks the FTSE/Xinhua China 25 index) have correlated well to their benchmark since the March low and while the ATR of the FXI has dropped by about 12.17%, the ATR of the FXP has fallen a significant 88.08%. Low ATRs usually indicate consolidation periods of sideways action and that is just what we are seeing with the FXP. (See chart here.)

Historically, ultra short funds and this one in particular have notable volatility. The FXP is down over 72% for the year but the price action we have seen in the last seven months may be afford an unusual opportunity.

It seems counterintuitive to suggest that an ultra short China fund be utilized as a hedge against the U.S. stock market but this is the reasoning behind the premise. On Friday the FXP was up 6.81% and the S&P 500 index was down 2.81%. A triple inverse relationship on the reward side. The important risk component, however, is the compressed price range and the tight stop loss levels. The FXP closed at $9.09 on Friday, there is support at $8.41 and the low for the year is $7.87 and, while this ETF has been subject to gap openings, volatility, as we explained, has been greatly subdued.

If you believe that it is unlikely that we see the U.S. stock market make any sustained move higher in the near future or that there could be a significant decline from current levels, then buying the FXP with a close stop sets up a risk/reward ratio hedge that is compelling. The 50 day moving average is at $9.33, just above Friday’s close, the daily RSI is moving over 50 and there is a slight bullish divergence in the daily MacD leaving the FXP positioned to advance.

The fundamental idea that emerging markets are more likely to overshoot on either side of a significant move in the U.S. market is additional support for premise of this hedge.

Disclosure: Long FXP

Comments

[Alphameister:]

I prefer an opposite approach. I like the reward-risk ratio for Chinese stocks so much more than for US stocks that my long positions are concentrated in China and I am net short the US by holding TWM, a leveraged bearish bet on the Russell 2000 and my largest position by a wide margin. TWM was up 14% last week. My long positions declined last week but much less than did most US stocks.

Nov 01 01:21 PM

[Oscar Sahlberg:]

If you want to short China, DO NOT use the FXP, instead go short the FXI directly (adjust your position depending on what your appetite for volatility is accordingly). For example, if you had gone short FXI vs Long FXP, you would have actually made money over the past 2 years (I have included the inverse of FXI) rather than being long the FXP (which completely would have destroyed your capital). This has to do with the underlying setup with the swap, which is basically an "double or nothing" structure. Please see the link below for the evidence of what I mean... (FXI inverted left axis rebased to 100 - so you're up when you are short it--- FXP right hand sight, you're long it).. Also note that if FXI halves to its all time low tomorrow, FXP will only go to 16 NOT the high of 170...

img193.imageshack.us/i...

Nov 03 04:02 PM