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In the wake of Tuesday night’s 7% selloff in China, it’s worth taking a minute to talk about risk management. I am a big believer in the “third time is the charm” scenario, because I believe that the bubble will not pop until people have been systematically conditioned to buy the dips. Consider the first two large China dips to be this sort of conditioning, and it will be the recipe that will set the pigs out for slaughter as people jump in to buy the future dips.

That being said, I cannot predict exactly when the next dip will come, and China remains a very lucratively place to invest–provided that it is done cautiously and with valuation in mind. I currently have a sizeable chunk of my portfolio in Harbin Electric (NASDAQ:HRBN) and China 3C Group (CHCG.OB), both of which I believe are undervalued on any market but both of which also happen to be Chinese companies. Therefore, it is worthwhile to take stock of the fact that while these stocks may be undervalued, they are nevertheless likely to have a significant correlation to the Chinese indices.

With that risk in mind, I think it is wise to have a look at a bit of arbitrage here, and I might begin to run a Chinese short book against my longs. I have not scouted individual companies for this pair trade, and I’m not totally convinced that I will use individual companies in an attempt to make this trade. My worry with individual companies is that, with Chinese companies in particular, one individual stock can get away from me and sprint much higher over the near term, thereby wiping me out.

Instead, I’m probably more likely to short one of the Chinese ETFs such as the PGJ or the FXI. The other option would be to buy puts under the ETFs in order to protect my portfolio against a China crash. Either way, running a short book against my current Chinese holdings should help to dampen any correlation effects from these holdings from blips in the Chinese market, allowing me to stick with these holdings until the stocks are afforded more normal valuations. I’ve yet to actually enact the trade, and I don’t think that now is exactly the right time, but it is an effective tool for risk management in choppy markets such as China right now.

Source: Is it Time for a Chinese Pair Trade?