What’s Institutional-Grade Options?

We’ve recruited Benedict Maynard, the guy who literally wrote the book on options trade, to produce a fortnightly newsletter that shows you how to trade options intelligently.

No stupid scams. No naked shorts. He’s going to teach you the techniques he refined over 20 years on the trading desk in London.

Each issue will focus on a specific investment thesis and then show you how to build a trade around it.

What’s today’s idea?

Chinese large-cap stock call options

The Chinese stock market has been on a tremendous losing streak.

Indices such as the ​China Large-cap 50 index​ have recently hit October 2022 lows, which were already the lowest since the Global Financial Crisis in 2008. It is now about the cheapest liquid large-cap index in the world by P/E ratio.

Further, Chinese large caps are the world's most widely shorted mega-cap stocks by institutional investors.

The Chinese authorities have been pumping increasing liquidity and support into the market over recent months to combat this.

Moreover, sentiment toward the Hang Seng Index is turning around. I used the wonderful ​DeepSearchLabs​ app to test sentiment against price movement, and you can sort of see where things may be going.

All the ingredients are in place for a short-term squeeze higher over the next few months, and I want to share two strategies that will make money from this.

Both implementations use options that expire on June 28th. The first and simplest implementation generates a 460% return if the index regains its 12-month high. The second, which is more complex, costs nothing to buy but generates about half the return in the same scenario, potentially making more as the year progresses.

The underlying ETF:

The iShares China Large-Cap ETF (​FXI​) tracks and index of the 50 largest companies in China trading on the Hong Kong stock exchange. The table below shows the top 10 holdings.

These are highly profitable companies with global reach.

Alibaba, for instance, is the Chinese equivalent of Amazon but delivered over 2.5x Amazon’s earnings per share this month. Its sales were about one-quarter of Amazon’s despite having just one-tenth of Amazon’s market cap.

It trades at a multiple of just 9 times trailing earnings, whereas Amazon trades at 62 times.

In addition, the index also contains some of the largest banks in the world.

However, deeply negative sentiment towards the Chinese economy over the last few years has justifiably sent their stock market crashing down. The Chinese government is still trying to deflate its property bubble, while high-profile regulatory crackdowns have scared foreign investors, causing them to pull funds out of the country’s stock markets.

Here's a zoomed-out chart of FXI. You can see it sits at a key level relative to its 18-year history.

As mentioned, the index is now historically cheap.

It trades with a price-to-earnings multiple of just 10, which is 1st percentile throughout its 18-year history. Compare this with the US Large-cap index, which is trading at the 96th percentile of its 144-year history.

Furthermore, allocation to Chinese equities by institutional investors is at rock bottom.

In an institutional survey run by Bank of America Merrill Lynch this month, not only was Chinese equities the most consensus short exposure, but it was also considered the second most crowded trade (after owning the ‘Magnificent Seven’ stocks).

Given the right catalyst, this all points to a meaningful short cover rally. This is not to say that the economic woes facing the Chinese economy are soon to be resolved, just that the powder is dry and that any spark could ignite a short covering.

Short coverings are often violent in nature and become self-fulfilling, as rising prices cause investors to close out short positions, thereby pushing prices even higher.

What could cause that spark?

The Chinese authorities have enacted the immense measures over recent months to support the economy and the stock market. The last six months have seen over $110bn injections of support by the Chinese central bank into its economy.

This is a lot of money, even in China, and it's evidence that they are clearly changing policy. In January, the Chinese Premiere called for “more forceful and effective measures to stabilize the market and boost confidence,” and these have arrived in the form of wider trading curbs as well as using the nation’s sovereign wealth fund to buy the stock market directly (often referred to as the ‘National Team’).

The fact that ​President Xi is getting involved directly​ suggests that there is sufficient motivation to attempt to enforce a stock market floor.

Remember – we just need the market to stop falling to cause investors to begin taking profits in short positions, thereby engineering a self-perpetuating squeeze higher.

The trade

We’re playing a short-term bounce, so FXI call options that expire on June 28th will do.

I think two trades will work well:

That’s all for today. Special thanks to Benedict Maynard.

Cheers,

Wyatt