Chinese stocks have seen breathtaking returns over the past year. Since last April, the ETF tracking the FTSE China 25 (FXI) is up almost 50 percent. But Stacey Gilbert, head of derivative strategy at Susquehanna, says that high levels of leverage can be credited with the move, which means that Chinese stocks could soon run into trouble.
"Leverage in the local Chinese market had tripled over the past year to $1.7 trillion yuan or roughly $275 billion U.S. dollars," Gilbert said. "While that does not make a pullback imminent by any means, one thought we had was if there were a pullback, there might be increased volatility to the downside as margin calls were triggered."
To take advantage of a drop in the FXI—or even just to protect a long position—Gilbert is looking to buy puts in the options market. Puts are bearish bets giving buyers the right to sell a stock or ETF at a set price within a specific time frame.
However, puts have become more expensive as investors get more concerned about Chinese stocks. Gilbert notes that FXI's option prices are now near two-year highs. "It makes buying these options outright difficult to justify," she said.
Instead, Gilbert is looking at buying a put spread. This strategy involves buying a put while simultaneously selling a put with a lower strike price to offset some of the costs.
Specifically, she is interested in the 52.50/47.50 put spread expiring in June. Gilbert is paying $2.46 for the 52.50-strike puts and collecting 63 cents for the 47.50-strike puts. That means the net cost of this strategy is $1.83.
This strategy could also give traders amplified returns should the bearish call turn out to be accurate. If the FXI falls 10 percent from Tuesday's closing price to $47.50—the lower of the two strike prices—the strategy will be worth $5.
"Our initial cash outlay was $1.83, so that would give us a profit of $3.17 or almost 175 percent return for a 10 percent pullback in FXI," Gilbert explained.
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