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Being The Bookie – Playing China’s Wild Market With Options

Jul. 11, 2015 10:38 AM ETFXI, HAO-OLD
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In Mark Spitznagel's book, The Dao of Capital, Mark describes that fortunes are made while waiting patiently until the perfect moment to strike, and then when everyone is of the same opinion, take the contrary opinion and invest accordingly. The quasi-philosophic book, which I will admit, was dry at times, essentially preached, in plain English, to always be the buyer/seller of last resort, or in even more plain English, the "bookie." I see an opportunity to be the bookie right now with an old, very liquid, China ETF, (FXI).

Now, the Chinese market has had quite a ride, with FXI, which only tracks 25 Chinese large-cap companies, up 20% between March and April and then of course losing all of its gains in the proceeding weeks. The selling intensified and the Chinese government stepped in to try and help, banning all selling of stocks. Here's where it gets interesting though. When one looks at the implied volatility option traders are pricing into their option trades, it's at its highest level since the 2011 mini-bear market. As of today, it's pricing in a roughly 40% move over the next year. Go back two weeks ago and that number was 25%; in 2013, it bottomed near 15%. Do I know if the market is going up or down from here? No, and a bookie wouldn't know either whether "Horse #1" or "Horse #2" is going to win in the next horse race, he (and we) just know that we have an opportunity to make money by playing off other's psychology.

What's the trade? Non-directional, obviously. Implied volatility is highest at the near term July options, but not high enough compared to that of the August options (see March 2009 in the S&P 500 for an example) to warrant a calendar spread. This leaves us with a few choices. A butterfly or condor could be appropriate, but bid-asks spreads will certainly take a chunk out of our profits, so let's trade as few contracts as possible. Looks like the best option play is to use the dreaded phrase "going naked" and sell a strangle.

The strangle is a not a play for those who are faint at heart, or for that matter, for those not approved to sell naked calls. You must have a risk-management strategy, so if things don't go your way, It's a simple strategy. Sell a put and sell a call and hope the price stays range-bound and/or implied volatility decreases. You can set the range yourself. At this point, I'm using price projection bands, which are bands set around a linear regression line, to choose my range. I'm using the July options which expire on the 25th because they have both a high implied volatility priced into the options, yet time decay has not significantly devalued the options yet (as opposed to the options expiring on the 18th). The trades are to sell the $44 call on FXI and the $38 call on FXI. Your breakeven points, after receiving a $1.10 per spread, are roughly $36.90 and $45.10 on FXI. Those breakeven points will be your stop-loss levels, setting your maximum loss at about $100/spread. Remember though, time decay will be on your side, so if those levels are hit say, next Monday, that maximum loss is cut in half to $50/spread. (See risk profile below)

It's a "picking pennies up in front of a steamroller" play for sure, but we have a risk management strategy and literally have almost $10 of "wiggle room" in a stock which is only trading at $43. Remember, we are taking advantage of fear in the market, and to do so, we have to get out of our own comfort zone. So, if you decide to make the trade, stick to the game plan and don't be overly concerned about the intraday fluctuations of FXI as long as the stop-losses are not being touched. Happy trading friends.

~Metrotrader

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