Through the first half of the year, Japan held the coveted title of the world’s strongest market. At the height of their reign, the Nikkei Index — Japan’s equivalent of the Dow Jones Industrial Average — was up a breathtaking 51% year-to-date. That’s an annualized return of over 100% … for an index, no less!
Of course, that rate of ascent is far from sustainable and bound to hit the skids at some point. Reality came home to roost in mid-May as weak economic data along with a groundswell of profit-taking led to a sharp correction in the overheated market. The selling frenzy was no doubt exacerbated by a strengthening in Japan’s currency, the yen.
The inverse relationship between the yen and Japan’s stock market is easily seen by overlaying both assets on a price chart. We can use the Wisdom Tree Japan Hedged Equity ETF (DXJ) to represent Japan in the comparison. It’s one of the more popular — and more importantly, tradable — ETFs tracking Japan’s stock market.
When the monster bull market kicked off in December 2012, DXJ was aided by a weakening yen. In May, the flip was switched and the relentless decline in the yen finally … well, relented. Since then, the yen has formed a higher pivot low, striking more of a neutral-to-mildly bullish posture.
Unfortunately, the nascent strength in the yen has come at the expense of Japanese stocks, which have formed a lower pivot high and fallen back beneath both the 20- and 50-day moving averages.
The correlation study shown in the bottom panel of the chart shines further light on just how extreme the negative relationship has been. One thing is for sure — as long as the yen and Japan’s market sit on opposite sides of the teeter-totter, a continued rise in the yen will bring nothing but pain to Japanese stocks.
Traders looking for additional stability or even more upside in Japan’s currency can profit from their forecast by trading options on the CurrencyShares Japanese Yen Trust (FXY), an ETF that moves in lockstep with the yen.
A closer look at the FXY shows that the higher pivot low and subsequent rebound have lifted the recovering fund back above the 50-day moving average. What’s more, this key indicator of the intermediate trend is now rising slightly.
One play worth consideration — particularly if you’re comfortable betting that FXY remains above the higher pivot low at $97 — is selling a Sep 96-93 bull put spread for 58 cents. To enter the spread, sell to open the Sep 96 put while buying to open the 93 put. The max profit is limited to the 58-cent credit and will be captured provided FXY remains above $96. The max loss is the distance between strikes minus the net credit, or $2.42, and will be incurred if FXY sits below $93 at expiration.
To minimize the risk, you could exit early if FXY falls beneath support at $97 or if it reaches the short strike at $96.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.