Participate in the Emerging-Markets Retreat With Puts

by Tyler Craig | March 13, 2013 8:31 am

What began as a global rally off the November 2012 lows has slowly morphed into a bull run centered in the good ol’ U.S. of A.

The ascent from the autumn bottom initially boasted broad participation from emerging markets like China and South Korea to eurozone countries like Italy and Spain. And yet, as the rally has grown long in the tooth, many of the S&P 500’s foreign counterparts have slowly given back their early gains, creating quite the divergence in performance over the past month.

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Consider the following chart overlaying the S&P 500 Index with the iShares Emerging Markets Index Fund (NYSE:EEM[1]). While the S&P 500 has continued to climb during the past two months, EEM has faltered notably. Historically, both securities have exhibited a strong positive correlation — rising and falling together. Though each might blaze its own path from time to time, the decoupling typically doesn’t last.

As shown in the indicator window of the accompanying chart (red circles), the last two times the correlation fell into negative territory, it quickly rebounded. Either the current weakness in EEM will drag down the S&P 500, or the strength in the S&P 500 will eventually lift EEM.

Time will tell which path the resolution of the current divergence follows, but if recent history is any indication, weakness in emerging markets should lead to weakness in the S&P 500.

Aside from taking this development as a cautionary tale for U.S. markets, traders anticipating more downside in emerging markets also could consider placing bearish bets directly on EEM. With the implied volatility off EEM recently falling to multiyear lows, its options can be purchased on the cheap.

Aggressive traders could purchase the May 44 put for $1.35 or better. The risk is limited to the initial $1.35 paid, and the reward is unlimited, offering unfettered participation to a continued slide in EEM.

Those looking for a more hedged bet could purchase the May 44-42 put spread by buying the May 44 put and selling the May 42 put for a net debit of 75 cents. The max risk is limited to the initial 75 cents paid, while the max reward is limited to the distance between strikes minus the net debit, or $1.25.

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

  1. EEM:

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