Brazilian stocks and the Brazilian currency rose significantly Friday, reversing the massive Thursday plunge in both that attended a political scandal involving the country's president.
After a drop that wiped out nearly all of the Brazilian Bovespa index's substantial year-to-date gains, investors are now positioning themselves for potential upside for the group, according to strategists. But risk for the country's market is still apparent.
"It is hard to overstate how painful this move must be for EM investors and trend followers," Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, wrote Friday in a note to clients.
The MSCI Brazil ETF (EWZ), one popular U.S.-listed exchange-traded fund that tracks Brazilian stocks, fell more than 16 percent on Thursday after corruption allegations emerged against Brazilian President Michel Temer, which he has denied. This has led to calls for his impeachment — which would be the second endured by Brazil in about a year.
Interestingly, Chintawongvanich observed that after the plunge, traders do not to appear to expect large moves to the upside or downside. That suggests that options might be underpriced, and leads the strategist to recommend buying bullish call options on the EWZ.
As an intriguing sidenote, Chintawongvanich observed an incremental buildup in put buying leading up to Thursday's sell-off. While the markets were clearly taken by surprise on Thursday, "some investors appear to have been hedging against a major selloff in Brazilian equities and FX," he wrote.
This is the optimal time to play Brazilian equities with options, said Stacey Gilbert, head of derivative strategy at Susquehanna. She noted, too, that positioning is not yet at extremes on either side of volatility bets, and there is certainly evidence of investors positioning for a potential rally ahead.
Even still, she said Thursday on CNBC's "Power Lunch" that "[t]his is a substantially volatile and risky market."
This would suggest buying call options — which offer unlimited upside potential with fixed downside risk — rather than the ETF outright.
Looking to year-end, the options market is pricing in almost a 40 percent probability that Brazilian equities advance or decline 30 percent from current levels, Gilbert pointed out. By comparison, that type of move for U.S. equities is seen as less than a 5 percent chance, based on options prices.
From a fundamental standpoint, the Brazilian market just looks too risky an investment, said Chad Morganlander, portfolio manager at Washington Crossing Advisors.
"I'd stay away from Brazil. Corruption has always been the critical issue in Brazil; investors thought that was behind them, and obviously now they know it's certainly not," Morganlander said Thursday in an interview on "Power Lunch."
The reason why the market initially moved higher this year was because investors believed reform was coming after the impeachment of former President Dilma Rousseff, and there was hope the economy would improve.
"We believe on a fundamental basis the economy is going to be slower than everybody is expecting. We also believe that commodities — and that's a commodity-based economy — is going to roll over, hence we think they are going to have more trouble there. And in particular, their major customer is China, and we believe their reforms are going to have a major impact within the Brazilian market," he said.
If the equities fall further, and if the currency declines further, "then we would start picking through the rubble."