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.