The Year's Final Week: Trading Opportunities in China

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Includes: BIDU, EWH, FMCN, FXI, HAO, RIO, VALE
by: Mercenary Trader

The trading week between Christmas and New Year's Day is notoriously quiet.

At this point, most individual investors have finalized their tax planning and asset allocation decisions. Institutional managers should have been proactive with window dressing because of the anticipated light liquidity.

Typically, there is little additional macro economic news during this period because even policy makers and other macro drivers take time off over the holidays rather than trying to force issues when the majority of participants are much less active.

This year’s “in-between-week” may a bit more active – especially after China used the holiday weekend to hike interest rates in an attempt to ward off mounting inflation. The leader of emerging markets (EM) has been a deflationary force for the majority of developed nations, but itself is fighting a bitter battle against domestic inflation at home.

News of the rate hike has Chinese indices off in pre-market trading and could set up a number of opportunities to add horizontal and vertical exposure to the bearish base of short EM exposure that we have already built.

So while we will be using an extra measure of caution when setting up new trades in this illiquid environment, it looks like China will offer us a number of trading opportunities for the holiday week ahead. Let’s take a quick look at some of these setups …

The Broad Picture

With a number of liquid ETFs available, it’s fairly easy to quickly gain diversified exposure to China as a whole. The Mercenary portfolios took an initial short position in iShares China 25 (NYSEARCA:FXI) on November 12, when the index began to reverse after hitting a multi-year high.

On December 8, we took an opportunity to add to the position as bearish momentum picked up and the fundamental picture for China continued to point to tighter policy decisions and slowing growth. This week’s action could give us yet another opportunity to pyramid into larger exposure.

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The iShares Hong Kong Fund (NYSEARCA:EWH) is another name we are actively trading as momentum has reversed, and the index is showing signs of topping. The action over the pre-Christmas holiday sets up an interesting short-term pattern that could offer an excellent chance for us to add vertical exposure.

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This morning, we are watching a potential setup in Guggenheim China Small Cap (NYSEARCA:HAO) – yet another broad China short. The beauty of the Mercenary approach is that as we gain traction trading a particular theme, we are able to tighten our existing risk points while adding new exposure along the way.

With this method, we end up taking large shots when our initial thesis is proved correct – while at the same time keeping our risk firmly in check.

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China Momentum Stalls

Baidu Inc. (NASDAQ:BIDU) has been a “go-to” name when it comes to China growth exposure. Fund managers like the name because it has plenty of liquidity and offers access to China’s growing online community. But with the stock trading at a premium multiple, any disappointment could quickly cause a panic.

Two weeks ago, BIDU broke down from a tight consolidation, triggering our short entry, and then quickly giving us a chance to take half profits off the table.

A minor rebound during the last few trading sessions makes for a tempting situation to add exposure back to the trade. In the event that BIDU broke down from here, we could quickly increase our position size while simultaneously tightening our risk point. The result would be more exposure, less risk and a potential home run as traders hit the exit points.

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Focus Media (NASDAQ:FMCN) is another name leveraged to the Chinese consumer. While the stock doesn’t carry quite the multiple that BIDU features, rising inflation and the most recent rate hike are certainly headwinds that will be difficult for the company to overcome. If the growth assumptions are called into question – or if FMCN actually sees a contraction in earnings, mutual funds will quickly cut ties and FMCN could quickly begin trading in the mid- to low-teens – giving up 25% to 40% along the way.

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Global Effects

If China demand begins to slow as a result of a heightening cycle, we could see industrial metals quickly come under pressure. Of course, miners for these metals can offer some of the best trading opportunities, and we have some of the largest producers at the top of our radar list.

Vale, S.A. (NYSE:VALE), the Brazilian metals miner, has pushed right up to a resistance area near $34.50. It doesn’t pay to jump the gun on this trade, as we could still see energetic bulls attempt to ignite a breakout. But if the stock stalls at this level, it would offer a great asymmetrical situation with a risk point just above recent highs and plenty of runway for the stock to trade lower.

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Similarly, Rio Tinto PLC (NYSE:RIO) has spent the last few weeks in a relatively tight range below $73-ish resistance. If the December lows are broken, momentum could quickly accelerate and hard asset bulls could be caught leaning the wrong way.

We don’t have a pending trade on the books yet as we need to see added confirmation before pulling the trigger, but the setup looks attractive and once again we’re looking at a situation with asymmetric risk and return dynamics.

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Balance and Exposure

As a general rule, we aim to keep a relatively balanced book with pending trades or active exposure representing both bullish and bearish opportunities. This approach keeps portfolio volatility in check, and gives us the ability to profit from various “risk-on” or “risk-off” market swings.

Heading into the end of the year, we still have modest exposure to precious metals along with a few positions that should benefit from agflation price ramps. Should the action turn unexpectedly bullish, these areas will help offset our growing short exposure in China.

At the same time, however, we’re willing to put a bit more weight on the bearish side of the ledger. Broad bullish sentiment, an overbought market, and macro risks all point to a high-risk environment … one which offers tremendous opportunity for bearish traders.

So while we do have a relatively light holiday week in front of us, don’t let your guard down. It looks like there will be plenty of action to kick off the week and light volume could add extra volatility.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here: http://mercenarytrader.com/legal/.