Emerging Market ETFs - Option Investability Index™

Sep. 26, 2013 5:43 PM ETEWM, EWW, VWO, EEM, EWY, EWZ, FXI, RSX, EPI
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Contributor Since 2013

John Diamondopoulos provides commentary on the global financial markets through the Macro Blog. He is the chief trader and macro analyst at a global macro advisory/research firm utilizing option strategies to achieve better risk/reward trades. John brings over 15 years of highly successful options trading experience particularly during times of financial crises where macro factors are crucial to trading success.  Regarding research, his main interests are financial crises and the sociological and behavioral aspects of financial markets. John is specifically interested in the political aspects of financial crises and how traders make financial decisions. Currently, he is completing his PhD at Birkbeck College, University of London. John is focused on the development of a theory of financial crises and which is entitled: 'The Socio-political Theory of Crises (SPTC).' 

To capture major and minor market moves in emerging markets, I frequently use ETFs (Exchange Traded Funds) that meet certain standards regarding volume, open interest and liquidity measures (bid-ask, etc).

Thus, I only trade emerging market ETFs that meet my standards on option investability. For this purpose I have created the Option Investability Index™ - Oii™, which is a proprietary index that rates ETFs and equities on a scale of 1 to 5 (with 5 being the best). The higher the number, the higher your confidence in terms of implementing the appropriate option strategy to take advantage of price movements in emerging markets.

For example, a score of 3 is fine. But this might be a little risky depending on the option strategy and market conditions, thus you should really look for scores of 4 and 5 to cover most market conditions. It should be noted that during abnormal market conditions, such as during a financial crisis, this might not true and to be on the safe side you might want to reduce the index score by 1 or 2 levels.

Looking at the table below, you will notice that certain ETFs - (EEM), (FXI), (EPI), (EWZ), (RSX), and (EWY) score very high (4 or 5). These ETFs correspond to the iShares Emerging Markets, China, India, Brazil, Russia and South Korea respectively. You should feel confident in most market conditions with these particular ETFs.

Also acceptable, but with a bit of caution, are the ETFs of Mexico (EWW), Malaysia (EWM) and Vanguard Emerging Markets (VWO).

What is not listed in the table below are ETFs from the several countries: South Africa, Indonesia, Turkey, Philippines, Poland, Thailand, Chile, Vietnam and Columbia. Some of these might be OK to use during expected major market moves and under certain conditions.

Emerging Market ETFs - Option Investability Index™ - Oii™
25th September 2013    
Countries and Regions ETF ETF name Option Investability Index™ - Oii™
Global EEM iShares MSCI Emerging Markets ETF 5
  VWO Vanguard FTSE Emerging Markets ETF 2
China FXI iShares China Large-Cap ETF 5
Brazil EWZ iShares MSCI Brazil Capped ETF 5
India EPI WisdomTree India Earnings Fund 5
Russia RSX Market Vectors Russia Index ETF 4
Mexico EWW iShares MSCI Mexico Capped ETF 3
South Korea EWY iShares MSCI South Korea Capped ETF 4
Malaysia EWM iShares MSCI Malaysia ETF 2

Last week, the FED decision sparked numerous emerging markets. Considering the current account deficits of India, Turkey and Indonesia for example, the risks going forward are growing for these countries.

A FED decision is expected by as early as the next meeting in October and more reasonably by December. The question is how one might play future volatility in these markets using ETFs as a vehicle. The problem as can be seen in the chart above is that Turkish and Indonesian ETFs are not listed since the score was very low (Turkey) or options were not available (Indonesia). Thus, India seems the better bet in terms of speculating with options on the WisdomTree India Earnings Fund .

For the meeting in October, a reasonable option strategy is a strangle, which is purchasing calls and puts that are slightly out of money. A medium size or large move in either direction should lead to a profitable trade while also covering the trading costs.

In contrast a straddle would be more expensive to implement since both the call and put would be at-the-money and trading costs would predominate here.

The expected FED decision should move markets enough to make a strangle strategy profitable. Since the direction of the expected FED decision in October is less certain this is probably the best strategy.

If the move does not happen in October, a more directional strategy such as buying a put would be better since you are speculating that the probability of the FED taking action is greater in December.

Below are visual representations of the two option strategies.

Source: pload.wikimedia.org/wikipedia/commons/thumb/2/2a/Long_strangle_option.svg/500px-Long_strangle_option.svg.png

Source: en.wikipedia.org/wiki/File:Long_put_option.svg

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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