Recently, it has been fashionable to bash Spain in the financial news media. What better way to label and identify “Spain” than through the iShares MSCI Spain Index ETF (EWP)? After all, according to a sampling of recent articles, Moody's has downgraded Spain's financial rating, Spain's industrial sector is in trouble, and Spain's banking system may be in for some serious struggles.
Let's face it....Spain is bringing up the tail end of those PIIGS. So perhaps that's reason enough for a contrarian trader to take a closer look. According to the iShares website, EWP is weighted a full 40% in just two stocks. One is an international bank, Banco Santander, (STD); the other is a worldwide telecommunications company, Telefonica, (TEF).
On its website, Banco Santander characterizes one of its strengths as “geographical diversification”:
Santander ’s geographical diversification is evenly balanced between developed and emerging markets. Its presence is concentrated in 9 major markets: Spain, Portugal, Germany, the UK, Brazil, Mexico, Chile, Argentina and the US, and in most of these markets it has attained high market shares in retail banking.
Similarly, on its website, Telefonica describes its global footprint as follows:
Telefónica is one of the world leaders integrated operator in the telecommunication sector, providing communication, information and entertainment solutions, with presence in Europe, Africa and Latin America.
Telefónica has one of the most international profiles in the sector with more than 60% of its business outside its home market and a reference point in the Spanish and Portuguese speaking market.
The respective weights of each of these “Spanish” stocks in the ETF is 22% for Banco Santander and 18.6% for Telefonica. No other stock presently has more than an 8% weighting in EWP, although the financial sector makes up about 43% of the total mix.
So perhaps you don't want to buy this ETF because of its diverse portfolio. As well, you may not be impressed with its focus on Spain, even though the focus may be misleading. How about the 5% dividend yield? Well, that has our attention, but we won't buy EWP for that reason alone.
Quite simply, we like EWP's charts and we like them now. On a weekly candlestick chart going back to its 2007 high, EWP has just broken out of a long term downtrend line. Going back four years, that is a fairly powerful signal. At the same time, for nearly a year EWP has been making higher lows and higher highs. We call that an uptrend. There is a significant Fibonacci support band between 38.50 - 42.00; and the moving averages we use have crossed over, signifying confirmation of the positive trend.
On a point and figure chart, EWP is trending upward and just achieved a triple top breakout buy signal. Importantly, it shows recent positive relative strength against a number of its emerging markets ETF peers including WisdomTree Emerging Markets Equity Income Fund (DEM), iShares MSCI Emerging Markets Index (EEM), and PowerShares DWA Emerging Markets Technical Leaders (PIE).
So how can we make a silk purse out of a PIIGS ear? Try this:
Buy EWP shares at 43.00 or better;
Buy 1 EWP May 41 put for 1.50 or better for every 100 shares you purchase.
The object in purchasing the put option is protection for the stock position. Some traders use stops; and while occasionally we do that, we prefer not using a hard stop in the stock markets; and we never use a stop in the options markets. In any event, the put option ensures that the maximum we can lose on this trade is 3.50, or about 8% of the total investment until mid-May when the option expires. By then, we would expect one of three things to happen:
- EWP continues its uptrend and the price moves above our entry point enough so that we become comfortable selling the put or allowing it to expire. Later, we would be looking to sell puts or covered calls in order to recover the 1.50 cost of our puts; or
EWP trades sideways to down, closing above 41.00 in mid-May, causing our protective put to expire worthless; or
- EWP trades below 41.00 in which case we sell back our put before it expires and we evaluate whether to continue with the position or exit the market with a 3.50 loss.
The least favored scenario is the second because the time will have passed without EWP having shown its hand. Our option will have expired and we will be required to evaluate whether it is worth the risk and possible additional expense to remain in the position through June to collect the anticipated dividend, typically paid in June and December.
The third scenario would not be good; however, sicker dogs have gotten well. Whether EWP falls to 30.00 or 3.00 we can only lose 3.50 on the trade as it is structured until mid-May. We could either exit or purchase more shares at a better bargain; and if the market sells off hard, chances are option implied volatility would skyrocket and we could sell put and/or call premium to pay for our put protection and give us some added cushion to our continuing risk of loss. Much would depend upon the chart picture under this scenario.
The most favored scenario is the first, even though the put would expire worthless or be sold at a loss. In the event EWP continues its trend, we could recover the cost of the put protection by selling covered calls later or selling puts under support to enhance income or accumulate more shares.
By having a plan to control our risk before we enter the trade, we take the guesswork out of what might happen, at least for a few months. The put option buys us time to have our evaluation of the chart confirmed and participate in the potential continuing success of the Spanish ETF.