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Tue, June 6 at 7:00PM ET

Emerging Markets’ Volatility Is Too Rich

The euphoria over the fiscal cliff deal hasn’t been isolated to the U.S. stock market only. This week’s risk-on rally was a widespread affair, with markets across the globe rocketing higher. Since the surge kicked off on Monday, the Vanguard All-World ex-US ETF (NYSE:VEU) is up 2.4%, while individual country-based ETFs like the China iShares (NYSE:FXI) and the Brazil iShares (NYSE:EWZ) are up 5.3% and 3.7%, respectively.

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Of course, the strength in foreign markets isn’t a new phenomenon. On the contrary, many markets outside the U.S. captured gains throughout the entire fourth quarter that put the 1% loss in the S&P 500 to shame. Take the outperformance in the iShares Emerging Markets Index Fund (NYSE:EEM) — which was up 7.3% on the quarter — for instance. Its strength is captured nicely by the rising relative strength line in the accompanying chart.

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Aside from the differences in price performance between the U.S. and the rest of the world, we’re also seeing some interesting disparities in their respective volatility markets.

As mentioned in my last article, the Volatility Index (CBOE:VIX) just experienced a drop of historic proportions. The two-day swoon has brought implied volatility (red line) below the 20-day historical volatility (blue line) of the S&P 500 Index as shown in the chart below.

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Interestingly, the VIX’s swan dive hasn’t been accompanied by a similar decline in the volatility of some non-U.S. markets. For example, the implied volatility of EEM options has remained stubbornly elevated despite the otherwise bullish action in the ETF of late. As shown in the volume chart here, the implied volatility of EEM still is hovering around 16% while the 20-day historical volatility is down around 10%.

In light of these differences, EEM appears the better underlying fund to use for short volatility strategies. Given its cheap share price as well as strong uptrend, selling put options is one strategy worth consideration. With EEM currently a tad overbought, though, you might want to wait and see if it pulls back to provide a better entry point.

Upon completion of the pullback, consider selling the February 43 put option for around 60 cents or better. The max reward is limited to the initial credit received and will be captured as long as EEM remains above $43 by Feb expiration. To reduce the risk, consider exiting the trade if EEM falls beneath the 50-day moving average at $42.

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

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