Chinese stocks are all the rage of late. Buyers can’t seem to get enough of the recent breakout in the iShares China Large-Cap ETF (NYSEARCA:FXI).
The follow-through has been relentless, driving FXI shares along a parabolic path skyward.
Opportunists should be viewing the ascent with an eye of skepticism, however. My inner contrarian is starting to growl and signs of excessive froth are rising in the marketplace.
The first sign that FXI has defied gravity for too long is illustrated by the Percentage Price Oscillator. It allows us to measure just how far FXI has risen from its 20-day moving average — in other words, how overbought it has become.
As shown below, this iShares ETF sits 6 percent above its 20-day exponential moving average. It rarely gets further away from the 20-day EMA than where it sits right now.
That means a pause or pullback is perhaps looming for FXI, at least in the short run.
Yet a second variable pointing to increased speculation in FXI is the runaway demand for out-of-the-money call options. This can be measured by viewing the implied volatility of upside calls versus downside puts. For example, with FXI trading near $46.50 the $50 calls are trading at an implied volatility of 24.87 while the $23 puts are trading with an implied volatility of 23.
What’s more, the implied volatility continues to increase as we move further out of the money on the call side. This dynamic usually only appears when market participants are in mega-speculation mode, bidding up call prices with abandon.
An Option Play for FXI Contrarians
Should the rally in FXI show signs of petering out in coming days, skeptics can position themselves to profit with May bear call spreads.
Sell the May $49/$52 call spreads for 41 cents. The maximum reward is limited to the initial 41-cent credit and will be captured provided FXI remains below $49 by expiration.
The maximum risk is limited to the distance between strikes minus the net credit, or $2.59, and will be lost if FXI rises above $52.
At the time of this writing Tyler Craig owned short call spreads on FXI.
