by Tyler Craig | February 13, 2013 8:23 am
While the S&P 500 Index has been continuing its slow grind higher, the iShares Emerging Markets Index Fund (NYSE:EEM) has quietly retreated to its rising 50-day moving average. Though the 4.2% drawdown doesn’t rise to the status of a major correction, it does at least provide a low-risk entry point for traders who believe the larger uptrend in EEM is likely to continue.
Click to Enlarge Before suggesting an options play to exploit a rebound in EEM, let’s familiarize ourselves with some characteristics of the fund.
Of all the ETFs that track foreign markets, EEM is undoubtedly one of the largest. Aside from its average daily volume which frequently exceeds 45 million shares, EEM also boasts super-active options with tight bid-ask spreads. Traders venturing into the options market have a bevy of choices to consider since EEM offers strike prices in 50-cent increments.
As the name of the fund implies, EEM offers exposure to a broad swath of nations falling under the “emerging markets” banner. Currently, the top four countries represented in the fund are China, South Korea, Brazil and Taiwan. Investors unwilling to pick winners and losers in the emerging-markets space can use EEM for exposure to the entire basket.
In light of the relatively cheap price tag of EEM, one higher-probability option strategy worth consideration is selling out-of-the-money put options. For example, you could sell the April 42 put for 53 cents or better. By selling a put, you obligate yourself to buy 100 shares if EEM should fall below $42 by April expiration. Given the 53 cents received at trade entry, your cost basis for the shares if you have to buy them would be $41.47, which is about a 5.6% discount to the current price.
The potential reward for the short put is limited to the initial premium received, or 53 cents. Provided EEM remains above $42, the put will expire worthless, allowing you to capture the entire profit.
To cover the potential risk, most brokers require you to put up around 10%-20% of the stock price as margin requirement. With EEM trading around $44, the margin required will probably be between $440 and $880 per contract.
If you’re unwilling to buy shares of EEM, simply close the trade by buying back the put if EEM falls beneath $42.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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