Pre-Holiday Trading: Zynga, China, And The Euro

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 |  Includes: FXE, HAO, ZNGA
by: Mercenary Trader

By Mike McDermott

It’s the week before Christmas and I don’t know about you, but I’ve still got a number of items to check off my shopping list (not to mention a basement full of things that need to be “assembled” before the big day). Throw in a few family gatherings, drinks with a couple of friends, and a pickup basketball game with the old gang from school – and it’s becoming a busy week.

And that’s the problem with trading this week. Traders have other things on their minds. Prop desks are being staffed with second string players, and rookies who have been given minimal latitude to maneuver. Most major allocation decisions have already been made – or they are postponed for the beginning of 2012. In short, this week and next are likely to feature low levels of liquidity, and unpredictable volatility on an intra-day basis.

From a trading perspective, there are really just two major issues that have meaningful potential to drive markets this week.

  1. The Debt Crisis in Europe – Funding issues, austerity measures, and ratings decisions aren’t likely to take time off for the holidays. So the drama in Europe still has potential for headline driven swings and “risk-on” / “risk-off” decisions by managers with exposure to Europe. (By the way, with correlation levels high, everyone has exposure to Europe.)
  2. Performance Anxiety – Mutual fund managers have largely fallen behind their benchmarks this year, as volatility along with redemptions / distributions have made it difficult to effectively manage assets. With many managers’ jobs on the line, don’t be surprised to see some last minute heroics push prices around this week and next.

As we trade our way through the week, we will be conservative in adding new positions – focusing more on tightening risk points and managing the modest exposure on our books. Despite the many challenges, it’s been a profitable trading year for the Mercenary trading book and we’re focused more on protecting those gains rather than pushing hard into the end of the year.

Below are a few areas we’re focusing on this week.

Bad News for Social Media IPOs

Zynga debuted on the Nasdaq Friday, pricing about 100 million shares at $10.00. The billion-dollar offering was the largest internet IPO since Google went public in 2004 – and it was priced at the high end of the expected range.

Unfortunately for participants in the deal, Zynga didn’t keep its $10.00 price tag. During the day, the stock lost as much as 10% of its value, settling at $9.50 per share – or a 5% loss. That’s bad news for such a widely anticipated IPO – especially considering the fact that ZNGA is a profitable company and investors are expecting significant growth out of the company for years to come.

I have to admit, I’m not a huge Facebook user, and I certainly don’t spend a lot of time playing games like Zynga’s now famous “Farmville” series. But the company’s “free to play” with premium items or services for sale has been proven to work for many of the Chinese gaming companies. An estimated 3% of Zynga’s gamers end up becoming paying subscribers. The question for investors is whether Zynga will continue to be able to grow – especially considering increasing competition from traditional console gaming companies like Electronic Arts (ERTS) and Activision Blizzard Inc. (NASDAQ:ATVI).

Considering the disappointing start, ZNGA could turn out to be an attractive short over the next two weeks. With IPO investors trapped below the high-water mark, there is a significant potential for massive liquidation. The $10 price level should now become resistance with investors willing to bail at this level if they can “get their money back” from this busted deal.

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Euro Consolidation

Our profitable euro short has been trading in a tight range after breaking to new lows early last week. The troubled currency has settled at the psychologically important 1.30 level (for the EUR/USD pair) and traders are watching the action carefully to determine whether this is a key support area (leading to a rebound) – or simply another stop along the bearish path.

If the currency pair continues to trade at this level for a few more days – and then breaks down sharply – it would give us a natural spot to tighten our risk point significantly. We’ve already locked in a small profit on this trade, but a new risk point just above the 1.30 consolidation would give us more than a 2R profit on the trade.

“2R” refers to our “reward-over-risk” measure – meaning our return would be more than twice our original capital at risk. For a discussion of standardized units of risk, take a look at the Drivers Manual Part IV.

If the euro does not break down from this level, we’ll be watching the rebound carefully to determine if a new swing high will be reached, or if this is a more substantial rebound (leading us to go ahead and cash out of our euro position).

Expect the action to continue to be headline driven with plenty of liquidity, but also plenty of volatility. The debt crisis isn’t likely to take a break for the holidays and the volatile nature of this market should be respected over the next two weeks.

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China Weakness – No Relief Yet

China’s economic growth has taken a backseat to the crisis in Europe, but the issues are still significant. Recent price data shows that inflation may be easing, but that comes with serious deceleration in the growth rate. If China’s growth stumbles, it will be big news for the broad global economy – investors are just too preoccupied with Europe to take note at this point.

Over the past two weeks, our short positions in Baidu Inc. (NASDAQ:BIDU) and Ctrip.com Inc. (NASDAQ:CTRP) have given us some nice unrealized gains – and our newest Chinese position in Youku.com Inc. (NYSE:YOKU) still looks promising. Portfolio Managers are lightening up on risk in this area, but premium stock price multiples still leave plenty of room for more profits on the short side.

Looking at the Guggenheim China Small Cap (NYSEARCA:HAO) ETF, it looks like we are sitting right on a key support level. This is a relatively illiquid ETF – in an illiquid market environment – but the pattern is still worth watching. If HAO breaks this level, and key Chinese stocks continue to trade lower, it would represent another confirmation of weakness in this area – one which could lead to much more liquidation in early 2012.

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Heading into the open, traders are bidding the pre-market futures modestly higher. The strength is probably due to some relief with no significant debt issues surfacing over the weekend, but the bottom line is that at this point there are more buyers than sellers.

It’s a choppy environment, so keep that exposure tight. The best use of time this week is probably outlining goals and expectations for 2012 rather than trying to book a few extra bips in the final two trading weeks of the year. At Mercenary Trader, we’re excited about the year ahead as we work on new research and trading initiatives, developing new product ideas, and building more value into our “community of ruthless profiteers."

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