Are Emerging Markets Actually Re-Emerging?

by Tyler Craig | July 12, 2013 12:08 pm

Thursday’s market surge was anything but a domestic affair; stocks across the world joined the bullish festivities, making it a truly global rally.

The return of strength in foreign markets represents an impressive about-face as many suffered dramatically during the recent June swoon in equity prices. Take the Vanguard All-World Ex Us Fund (VEU[1]), for example. From its May 22 peak, VEU fell as much as 14%, breaching its 200-day moving average in the process. At the same time, the iShares Emerging Markets Fund (EEM[2]) and iShares China Fund (FXI[3]) both fell 18%, respectively.

Yesterday, all three foreign based funds rallied by more than 3%, with China rocketing higher north of 5%. More important than the magnitude of the move is the fact that the technical picture of each ETF improved dramatically. Short-term resistance levels were broken, and higher pivot highs finally developed.

While these three amigos are giving back some of their gains in today’s trading session, that might merely represent a dip-buying opportunity — particularly if the retracement remains shallow. Let’s zero in on EEM to see how we might exploit its re-emergence.

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As shown in the accompanying chart, EEM has now developed both a higher pivot low and a higher pivot high, revealing a change in direction of the short-term trend. Furthermore, it has broken back above the 20-day moving average for the first time since the selling deluge kicked off on the infamous outside reversal day that occurred May 22.

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If we take a bird’s-eye view of the past four years of trading in EEM, the $36 level has proved a key support zone to enter longer-term bullish positions. It should come as no surprise, then, that the recent downturn terminated in this area.

In light of the cheaper price tag of EEM, one higher-probability play worth consideration is selling out-of-the-money August put options. Short puts effectively represent a bet that the underlying stock will not fall by more than a certain amount by expiration. If EEM is indeed turning to the topside, it shouldn’t drop back down that much from current prices.

You could sell the Aug 37 put for 55 cents or better. The max reward is limited to the initial 55 cents and will be captured if EEM remains above $37 by Aug expiration. The expiration breakeven price is $36.45 ($37-$0.55), so EEM can actually fall a bit below $37 while still yielding a profit. Typically the margin requirement for a short put ranges between 10% to 20% of the stock price, which comes out to about $370 to $740.

To reduce the risk, you could exit if EEM falls back below the put strike of $37.

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

  1. VEU:
  2. EEM:
  3. FXI:

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