(Amber Hestla-Barnhart) When traders think about Black Swans, they tend to recall the big market declines like the one we lived through in 2008 when a housing market meltdown led to a steep drop in stock prices. Black Swans can also be seen in positive surprises, as Federal Reserve action led to an equally steep upside reversal for stocks in March 2009.
Neither event could be accurately predicted in advance, but in both cases, the stock market did offer an indication that a big move was likely to occur shortly. Before prices have moved sharply in the past, volatility has contracted. While a volatility contraction signals a big move is probably going to occur, it does not tell us about the direction of that move.
Right now, we have a signal that a big move is likely to occur in China. Market volatility has contracted while we have news reports indicating that China's economy may be slowing down, and the central bank may be aggressively easing according to other reports.
In addition to internal factors, China's economy could be heavily influenced by events in Europe, its leading trading partner. Resolution of the euro problems, even another temporary patch, could push Chinese stocks up, but another crisis in Europe could cause them to plummet.
Despite the possibility that volatility could be just around the corner for China, the stock market, represented by iShares FTSE China 25 Index Fund (NYSE: FXI), is trading at the lowest level of volatility seen in six months. Traders who think the economy will avoid a deep slowdown could buy FXI, while traders believing a slowdown is inevitable can short FXI. Or, rather than choose a side in this debate, we can simply buy an options straddle.
This strategy is useful when we expect volatility to increase but don't know the direction of the expected price move. A straddle requires a trader to buy both a call and a put option on a stock or ETF, with both options contracts having the same expiration date and strike price.
FXI closed on Friday at $34.74. A call option expiring in December with a strike price of $35 is trading at about $1.33. A December put option contract with a $35 strike price is trading at about $1.74. Buying both, a trader will have a cost of $3.07. If FXI trades lower than $31.93 or above $38.07 before expiration, this straddle will be profitable.
The chart of FXI shows that there is possible resistance at $40 and support at $30. At those prices, this straddle would deliver a profit of about 63%.
The profit if FXI goes to $40 is derived from the call, which would have a value of at least $5. We can assume the put would be worth nothing. Combining the two, you would realize a profit of $1.93 (the $5 call value less the $3.07 cost to buy both options). If FXI falls to $30, the put would be worth $5, and the call would become worthless.
By buying one FXI Dec 35 Call and one FXI Dec 35 Put, you have a profitable trade if FXI moves by at least 9.6 percent before expiration, making this a way to profit from increased volatility. The maximum loss is the two options premiums, and that would be about 8.8 percent of the stock's price if FXI is relatively unchanged at expiration. The actual loss would be less than that amount if FXI closes in the money on either option.
This straddle trade gives you a win if the market moves but does not require knowing which direction the move will be in order to profit.
Action to Take
Buy one FXI Dec 35 Call and one FXI Dec 35 Put for a combined cost of $4 or less. Do not use a stop-loss. This trade will be closed at expiration. If FXI moves by about 10 percent in either direction, your profit will be dependent on how much you paid to enter the trade, i.e., at a combined cost of $3.07, you will have realized a 63 percent profit, while paying the full $4 would lower your profit to about 25 percent.
Amber Hestla-Barnhart does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.