Options For Both Sides Of China Fund FXI

Trader used options for both a floor and a ceiling for this China ETF.

Reviewed by: Scott Nations
Edited by: Scott Nations

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.

Exchange-traded funds make it easy to get instantaneous exposure to asset classes that might otherwise be difficult to participate in. Options on ETFs make it possible to get that instantaneous participation in payoff profiles that would otherwise be impossible.

On Wednesday, one institutional trader did both, using options to generate a unique payoff profile in the iShares China Large-Cap ETF (FXI | B-40) just after news broke that China was devaluing its currency in a surprise move.

FXI had a difficult second quarter, as you can see below, but the damage was manageable until the beginning of July, when the entire Chinese equity market swooned. FXI traded below $40 before recovering slightly. Now one institutional option trader is taking advantage of the turmoil to collect a premium by selling options at elevated levels, while speculating that FXI won’t fall below $39.

FXI traded as low as $38.88 on July 8, as the selling of Chinese equities reached its peak, so it’s easy to see why our option trader believes the $39 level will be the low for any future move.

How This Trade Works
To collect some premium and take advantage of his belief that $39 would be a floor, this trader sold 15,118 shares of the FXI $39 strike puts expiring in August for $0.54. The expiration date for August options is Friday, Aug. 21, so our option trader won’t be at risk for very long.

By selling these puts, our trader agrees to purchase 1,511,800 shares of FXI at $39.00 per share (each contract represents 100 shares), if the owner of the options decides to exercise them prior to expiration. The owner of the options will choose to exercise them if FXI is below $39.00 at expiration. In exchange for agreeing to buy FXI options if they’re below $39.00, our option seller collected $0.54 per share, or a total of $816,372.

Selling a put on FXI allows the put-seller to collect and keep the option premium. As long as FXI is above $39.00 when the options expire, that will be the put-seller’s profit. After expiration, he would be free to take his money and sell new put options or look for a new strategy.

If FXI is below $39.00 at option expiration, then he’s going to get the FXI shares “put” to him, meaning he’ll buy them at $39.00 per share, regardless of how much they’re trading below $39.00. Since he collected $0.54 per share when he sold the options, his net purchase price would be $38.46. You can see the payoff profile for selling these put options.

If the potential loss for selling these FXI puts continues to increase as FXI continues to drop, and since the maximum potential profit is just the $0.54 in options premium collected per share, why is our trader selling these puts now? Because the relative cost of these options has increased recently, as you can see below.

Options traders like to sell options when they’re expensive, just as a stock trader would prefer to short stock when it is expensive. Expensive options, coupled with the belief that the recent low just below $39.00 is a floor for FXI’s price, is likely the reason this trader is selling these puts.

Over time, options cost more than they’re worth, so it’s common for institutional options traders to want to initiate a position from the short side. The likelihood of a profit is pretty high, but the size of a potential loss can be pretty high as well.

Retail ETF option traders can learn from this trade, and it speaks volumes about this trader’s expectations for FXI. However, selling naked put-options simply to capture a little options premium is a strategy that is best left to institutional traders who can manage the loss.

At the time of this writing, the author held no positions in FXI. Follow Scott on Twitter @ScottNations.

Scott Nations is president and CIO of NationsShares. NationsShares is a leading developer of domestic and international option-based and option-enhanced investment products. He is the creator of VolDex (ticker symbol: VOLI), an improved measure of option-implied volatility on SPY, the S&P ETF.