Investor Alert
Andrew Giovinazzi

March 5, 2013, 12:02 p.m. EST

A potential options play on China

By Andrew Giovinazzi

As the Dow breaks into fresh highs this morning, the doom-and-gloom contingent have some short-covering to do. Frankly, this is hard to believe considering the crazy selloff we had last Monday.

What it does show is the two differing trajectories of investor sentiment. Namely the economy domestically continues to improve on just about every metric except employment. This is really due to the government scaling back and the private economy picking up for a net push. In the long run this is just fine as long as the private sector is absorbing what the public sector can no longer in employ and grows a bit beyond.

The economy was flat in the fourth quarter, and the market is up at a pretty nice clip from there. As far as the U.S. budget goes, we are three months into the year, and the deficit is finally coming in and stocks like that just fine.

The second and negative trajectory is the systemic issues that keep creeping in with the euro. That is clearly something the market cannot tolerate even a whiff of. My guess is from time to time, that issue will rear its ugly head until some form of tighter collaboration in European budgets can take hold. Take the European method of slow integration and compare that with the Chinese supreme bubble-bursting tools. I think raising taxes is a so/so way to attack the bubble in housing there, but it won't really kill speculation. They are also raising capital and credit requirements which are a much better way to go.

From a policy perspective, it is the overleverage that causes the issues. Overall, the economy is expected to grow around 7.5%. That still is not too bad, and the Chinese equity indexes are flat for the year as everyone hit the exit on the tax issues. That is really an opportunity.

I had a trade example in the iShares FTSE/Xinhua China 25 Index (PSE:FXI)  earlier that worked out well here at the Trading Deck and I think it is due for another look. The big difference now is the implied volatility in the options. The big selloff pushed implied volatilities up over 20%, which is a decent level to sell options in there. What I would like to find is bullish trade that sells volatility but has smaller risk. That trade is a butterfly-type strategy that is expecting a modest rise.

In a past column, I used a broken-wing fly to set up an upside move after the fiscal cliff in the SPY. I don't think the FXI will come close to that kind of upside, so the trade has a more modest shape. How about a trade along the lines of $40 in the FXI in the April cycle? Being able to buy the FXI index at start-of-the-year levels is just too enticing to pass up.

In this example, we would be buying the FXI Apr 38/40/42 butterfly for around .52 with the FXI trading 38.25 on 10 deltas for a 1 lot contract. You can play with this to allow more upside by adjusting the 42 strike to the 41 strike but that will make the fly more expensive.

Disclosure: Mr. Giovinazzi has a position in FXI.

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