Shares of the iShares China Large Cap ETF (NYSEARCA:FXI) finally showed some semblance of sanity and found their footing yesterday after a huge sell off. Chinese stocks have been pounded recently, dropping some 20% since early June. Certainly some of the selling is justified given the tariff turmoil and slowing growth concerns. The magnitude of the selling, though, is beginning to get overdone. Chinese stocks will likely begin to head higher over the next month.
The recent drubbing has made FXI comparatively attractive on a fundamental basis. A price-to-earnings ratio of only 10.20 and a dividend yield that’s close to 3.5% is rather inviting, especially when compared to the rather rich P/E of 24 and only 1.82% yield for the S&P 500. At some point, large fund managers will begin to take note and trim out U.S stocks and look into Chinese stocks. And that rotation should begin shortly.
From a technical basis, Chinese stocks are certainly getting oversold. Bollinger bands were pierced to the downside with a reading below zero. Previous instances when this occurred proved to mark significant short-term lows in Chinese stocks. Yesterday’s price action, with FXI gapping higher, is also indicative of a reversal in sentiment and may finally signal that the sellers have become exhausted.
The chart also shows the huge recent divergence between Chinese stocks (FXI) and U.S. stocks (S&P 500). Up until a few months ago, China and the U.S were highly correlated and moved in virtual lockstep. Since mid May, however, that correlation has broken down dramatically.
The S&P 500 has gained nearly 5% while FXI has fallen 20%. I expect the spread between the two to converge, with Chinese stocks out performing U.S. stocks over the coming weeks.
The recent drubbing has given a boost to implied volatility (IV), meaning option prices have become more expensive. This favors option selling strategies when constructing trades. So to position for the selling in Chinese stocks to abate, a bullish put spread makes sense.
Trade Ideas for Chinese Stocks
Buy the FXI Sep $36 puts and the sell FXI Sep $39 puts for a 35 cents net credit.
Maximum gain on the trade is $35-per-spread with maximum risk of $265-per-spread. Return on risk is 13.2%. The short $39 strike price provides a 4.38% downside cushion to the $40.98 closing price of FXI.
Tim may hold some of the aforementioned securities in one or more of his newsletters. Anyone interested in finding out more about Tim and his option-based strategies can go to https://marketfy.com/item/options-and-volatility.
