Wednesday, August 5, 2015

China's stock market

Having been away from the news (mainly because the internet was down) for a few days, I missed the latest and greatest about the Chinese stock market.  The news is not good, granted the panic seems to have ebbed but it remains that the past few weeks have been painful for investors (who are very leveraged).

Rumours are that there is an implicit price target of 4,500 for the Shanghai Composite index (the S&P 500 for China's main market) that today closed at around 3,600 off from its high of 5,100 (or about 35% lower -- which is bad).  The Chinese government has been working hard (and I mean really hard) at convincing the market that the market will go up, it has "encouraged" brokers to take large positions, ended the ability to IPO, it has made many stock "un-tradable" thereby reducing the volume of shares available.  In fact, the Chinese government has dubbed sellers as traitors!

If these rumours are true, and the Government can make the market calm down and start buying again there is still the 4,500 "liquidity" level -- at which the big stake holders will liquidate their unwilling participation in the market stabilisation efforts.  That, by the way, acts as a price barrier. In effect these stake holder have a put option (they can sell the shares to the market -- right now they cannot).  Now the nomenclature is not terribly important, but it means that the investors has a problem, as the prices of the market gravitates (eventually) close to 4,500 then liquidity will grow dramatically, and prices will fall.  In other words investors "know" that there is a real asymmetry of return, there is limited upside and massive downside -- that's a strategy, that as an investor you can take advantage of by using a series of puts or barrier options.  

The market is around 3,600 if you take the view that the government will do almost anything to get the price up beyond 4,200/4,400 then as an investor you have a massive opportunity -- not by shorting but by using derivatives!

My guess is that to limit the downside the best option (unintended pun) is to use some type of reverse straddle that will reduce your losses if the market plows through  4,500 but will give you massive upside if the market goes down further -- like to its 2013 level.

Honestly, I don't know who would allow you to write such an option position (especially since the Chinese market is closed to foreigners), but my guess is that it should be possible via the ETF market! At any rate this is almost a can't loose strategy (sure you've heard that before!!!), simply because the Chinese market is very "rich" the market perceives that barrier at 4,500 and so the cost of some of the protection options involved in this trade can be "cheap".

This, I think, is a sweet trade.

P.S.  I have to skin in the game here, no position either derivative or underlying stocks or ETF in the Chinese market.


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