Fade the Fear With a Short Put on EEM

by Tyler Craig | October 1, 2013 8:22 am

Fears of the government shutdown have begun to take their toll. With today’s downdraft extending the S&P 500’s losing streak to seven of the past eight days, the recent post-FOMC meeting euphoria seems a distant memory. And yet, for many traders, the current pullback provides a more compelling entry point in comparison to the overbought levels of weeks past. The dip in new leading regions like the iShares MSCI Emerging Markets ETF (EEM[1]) look particularly compelling.

Adding further allure to entering a bullish position or two on Monday’s down-gap is the behavior of the CBOE Volatility Index (VIX[2]). Widely lauded for its market sentiment-measuring properties, it aids the market timer in deciding when fear levels are excessive and contrarian positions worth entering.

Alongside the latest stock swoon, the VIX has rocketed higher, rising more than 24% in the past two trading sessions alone. The quick uptick in volatility expectations is no doubt a byproduct of elevated demand for options from nervous traders seeking protection for the final stages of the D.C. budget battle.

The latest VIX spike has driven the index above the upper Bollinger Band, indicating that fear has indeed reached extreme levels in the short-run. Many VIX-watchers claim the ascension of the VIX above the upper band to be a bullish omen, signaling market conditions might be ripe for a contrarian bullish trade.

Whether a bounce-back is imminent remains to be seen, but one thing we can hang our hats on is this — option sellers are receiving more compensation now than they have in many weeks.

VIXchart Fade the Fear With a Short Put on EEM
Click to Enlarge

As noted recently[3], the latest stock market rally has been led by foreign stocks, particularly those in the emerging-markets space. Driven in part by the tumbling U.S. dollar following the recent Fed meeting, foreign-stock ETFs were some of the biggest beneficiaries to the surprising no-taper decision. Traders afraid to chase them into the stratosphere will be happy to know the ongoing stock drop has brought them back to more reasonable levels for entry.

EEM Fade the Fear With a Short Put on EEM
Click to Enlarge

The EEM in particular looks primed for a short put play. Given the premiums that are offered in the November cycle, we can structure quite the high-probability play.

Sell the Nov 38.50 put for 60 cents or better. The max reward is limited to the initial 60 cents credit received and will be captured if EEM remains above $38.50 by expiration. If you’re a willing buyer of EEM, you could allow assignment if the puts sit in-the-money at expiration. Essentially, you would be obligated to buy 100 shares of the fund at a cost basis of $37.90 ($38.50 – $0.60), which is an alluring 12.5% discount to its recent high price of $43.32.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

Endnotes:
  1. EEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=EEM
  2. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX
  3. As noted recently: http://investorplace.com/2013/09/emerging-markets-are-leading-the-charge/

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