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Hedging your risk: What to expect for the Chinese markets

Posted November 14, 2007

“Smart folks look at both sides of the picture, and then step in where it makes sense. When we are right, we are rewarded for taking on risk. And hopefully when we are wrong, that is to say, when the less probable scenario comes to pass (as it inevitably will from time to time), we are properly armored against excess loss.” — Adam Lass

by Adam Lass, Today’sFinancialNews.com

Wednesday, November 14, 2007

Baltimore — (TFN): Over the past 11 trading days, the Chinese market has reminded us that while it is capable of jumping tall buildings in a single bound, it cannot withstand being hit by a speeding locomotive.

On Halloween, the FTSE/Xinhua China 50 ETF (FXI) scored a new all time high. By the following Monday, this collection of top tier Chinese stocks had gapped down nearly 15% on its way to an eventual $51/24% retracement.

Tyro Asian investors across the planet were reaching for phones… and defibrillators: Was this the end of the China story that many had warned of?

Certainly there was enough overhang, between the stories filtering out of the east of corrupt banking habits (hmmm, that sounds eerily familiar, but is another day’s tale), and the daily Stateside drumbeat of poisonous toy recalls (the latest: 400,000 lead-laden Curious George dolls – is nothing sacred!?!?)

Experienced China hands just smiled mysteriously and quietly spoke of necessary retracements and predictable consolidation patterns. And as predicted, Monday saw the China 50’s bottom at 167.99 hold. Tuesday gave us a recover rally, and Wednesday a gapping upside stroke.

Now we see Orientalists like HSBC’ Stephen Sun claim that this pattern fits three other major corrections seen in China shares during the last 18 months. His notes (brought to us via our friends at MarketWatch) draw our attention to pull backs in June of last year, and August and March of this year during which benchmark Chinese shares in fell 15% to 20% before rallying to new highs. Sun assures us that this is precisely what happened this time as well.

Sun and his cadre claim that Hong Kong shares benchmarks could hit new highs within the next few weeks. Fulbright Securities’ Francis Lun claims Hang Seng Index could retrace its 5,000-point decline from its high just shy of the 32,000-point level before the end of the month: “We are used to 1,000-point moves everyday now, so it can be accomplished in no time at all.”

Obviously Chinese shares are strong, but are they bullet proof? Not in the least: indeed, if anyone ever describes any single stock, bond or currency as on a guaranteed one-way ride, smile broadly and nod a lot, and when they blink, run the other way as fast as possible.

Our business is all about risk: that’s what makes fun… and viable. Smart folks look at both sides of the picture, and then step in where it makes sense. When we are right, we are rewarded for taking on risk. And hopefully when we are wrong, that is to say, when the less probable scenario comes to pass (as it inevitably will from time to time), we are properly armored against excess loss.

My own analyses of the FXI have indicated as early as the beginning of October of both the dominant probability of further highs and the distinct possibility of short-term downside of this magnitude.

The trick is to stay exposed to said upside while protecting against downside volatility. With this in mind, I recommended both primary calls and protective puts to suit the swings that came to pass.

As of Halloween the Taipan Trader FXI basket was worth $4,770, a gain of 47% over one month. As of when I sit to write to you, the leading call component is down some 58% from its high. However the basket as a whole down some 16% from inception, and remains positioned for further upside (as predicted by Sun, Lun et al). Should their prediction come to pass, this basket’s gains could easily rise over 100%.

However, we are also prepared against further downside. Indeed, should China’s rising trend truly breakdown, these puts would come into their own, quickly trading positions within the basket as the primary component moving forward. Nifty stuff, eh? But is even this position genuinely invulnerable?

I’ll be honest with you: the answer is of course a resounding “no.” Even a well-structured option basket like this is susceptible to time decay. Should the Chinese market suddenly decide to flatline for several months running, both long and short options would undergo a slow decline.

Fortunately, this particular scenario always offers plenty of time to exit with most of your cash intact. More importantly, it is incredibly unlikely. While the Chinese market has shown a remarkable propensity for dramatic rises and drops, dull complacency seems to be the very last thing on its mind.

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Posted by Adam Lass · Filed Under International Investing 

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