With the S&P 500 now trading only 1.5% below the all-time high of $2130.82, it is interesting to note that copper, widely considered an indicator of global economic health, is approaching a multi-year low.
The iPath Bloomberg Copper ETN (JJC), trading at $26.14, is now at levels last seen in March 2009, just as markets were emerging from the 2008 financial crisis.
Copper is also intricately tied to the well-being of the Chinese economy, and normally shows a fairly strong correlation to the Large Cap China ETF (FXI). Over the past month, however, the two have diverged, with FXI heading higher while copper heads lower.
Some of the recent divergence may be due to hedging by Chinese investors who are banned from shorting Chinese stocks. The strengthening dollar certainly has been a negative for commodities like copper as well. Regardless, the fact remains that copper has been diverging dramatically in recent weeks and and a breakdown from current levels below major support will likely lead to a selloff in the FXI.
How to Play the Breakdown in FXI
When copper trades at such a large relative discount to the FXI, it usually marks intermediate-term tops in Chinese stocks. Many loans in China are securitized (and over-securitized) by copper, and a breakdown in copper prices from current critical levels could lead to a swift unwinding of the leverage associated with these loans.
With FXI currently up against critical support at the $39 level, any further weakness in copper prices could be the catalyst for a technical breakdown in FXI.
Other stocks that have high correlation to copper prices, such as Freeport McMoran (FCX) and Caterpillar (CAT), will also suffer on any further weakness in copper, which would have a detrimental effect on U.S. share prices as well. While the worldwide economic slowdown has yet to translate to lower stock prices, it has certainly been reflected in commodity prices such as copper.
With implied volatility in FXI at the lowest level since July, option prices have become comparatively cheap, favoring long option strategies. So taking a long put position in the FXI to position for a sharp selloff in Chinese shares makes probabilistic sense at these levels.
After all, summer reminded us just how quickly Chinese stocks can plummet.
I would buy the monthly FXI Dec $38 puts for 95 cents (25.28% IV level), looking for FXI to meaningfully break the $39 support level.
With FXI closing at $38.95 on Friday, these puts are slightly out-of-the money. The risk on the trade is limited to the $95 premium paid per contract. My first profit objective is $36.50 on FXI, while I would use a time stop and exit the position by the end of November to preserve premium.
As of this writing, Tim Biggam had no position in the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can e-mail Tim at tbiggam@deltaderivatives.com.
