Trading Nation

This may be the only smart way to bet on China

Options show more downside for China?

The decline in Chinese stocks continued Wednesday, leading the Deutsche China A-Shares ETF to lose nearly 8 percent in two sessions. That may inspire some to play for a Chinese bounce. But due to an interesting market dynamic, there might be a far better way to do just that than simply buying the ETF.

As Chinese equities have fallen, and more and more investors seek to get exposure to the downside for speculation or hedging purposes, the shares have gotten increasingly difficult to short. According to the most recent data available to Susquehanna, the A-Shares ETF had a total short interest position of 7.1 million shares, with only 15.4 million outstanding. That means that finding the shares to short has become difficult and expensive.

Read More Cramer: Why China had to devalue the yuan

As an alternative, traders can get downside exposure by buying puts in the options market. These derivatives, which give their owner the right to sell a given stock at a specific time and price, have consequently risen in value.

Meanwhile, the other type of options, calls, have become less expensive. That's because hedging the purchase of a bullish call option has become more costly, making traders less inclined to bet on upside.

Now, calls and puts are known as derivatives because their value is derived from the price of the stock itself. One of the ways this relationship plays out is that the price of a call minus the price of a put should be (roughly) equivalent to the current price of the stock minus the strike price of the call and put in question. In general, buying the put and selling the call is similar to buying the stock itself, given that the trader who is long both options would have upside and downside exposure.

However, since the prices of the ASHR puts have risen while the price of the calls have fallen, the theorized relationship has not held. For instance, as of midday Wednesday when the (ASHR) was trading at $39.55, the December 40-strike call could be purchased for $3.30, while the December 40-strike put could be sold for $5.10. That means that an investor can take in a credit of $1.80 for getting synthetically long the stock at $40—implying a price of $38.20. That provides a 3.2 percent discount to the share price. (Incidentally, a high dividend yield can be one reason for a disparity such as this given that call owners don't receive the dividends that share owners do, but the ASHR's 10 cent yield is negligible.)

An investor looking at stock prices in Haikou, China, August 11, 2015.

The attractive options prices "[offer] those with contrarian bullish views an opportunity to put on long positions at a discounted price to the current stock price," Susquehanna's derivatives team points out. "While we have no directional opinion on the ETF, we recommend that those considering buying the underlying or who are already long the shares and not being paid an equitable rate for lending them out consider positioning via the options instead."

Read More China July data: A new slew of misses

However, such a trade isn't suitable for everyone. And in fact, Dennis Davitt of Harvest Volatility Advisors says that if forced to get long Chinese stocks, he would instead do the opposite of this trade, and buy the stock while simultaneously purchasing an admittedly expensive put.

"Sure, I'm overpaying by $2, but I'd rather give that $2 away," Davitt said. "If you buy this thing, you have to buy puts."

Technically, buying the shares and the puts is similar to simply buying a call. But since the ASHR's high volatility makes the calls expensive even though they're not as expensive as they might be, Davitt would rather not take the risk that volatility will decline, sapping his profits even if a bullish thesis turns out to be correct.