From the Top

Profiting From Volatile Emerging Markets

Employing the straddle strategy to great effect

by 8/8/2013 12:30 PM
Stocks quoted in this article:

The following is a reprint of the market commentary from the August edition of The Option Advisor, published on July 25. For more information or to subscribe to The Option Advisor, click here.

The alleged superior investment prospects for the so-called emerging markets have been much touted over the past decade by Wall Street and by professional fund managers. And those few "early mover" investors who acted before the crowd inevitably lumbered in by forsaking the U.S. market in favor of the likes of Brazil, Russia, Spain, and China did achieve a bang for their bucks, so to speak.

Over the 4-year period from April 2003 through October 2007, the iShares MSCI Emerging Markets Index ETF (EEM) almost quintupled at its peak, posting a 390% gain. And over that same period, the S&P could not even manage to double, gaining a relatively meager 79%. But since that general stock market peak in late 2007 (a period that encompassed a major positive shift by U.S. equity investors away from U.S. stocks and into overseas markets - generally of the "emerging" variety), the emerging markets have consistently underperformed U.S. stocks. In fact, the only emerging markets metric over this period that's shown up as consistently higher than its U.S. counterpart has been its volatility. And needless to say, a combination of weaker returns and higher volatility is exactly what is desired least in any investment, "alternative" or otherwise.

For an illustration of the "challenged" emerging markets returns, we need only acknowledge the year-to-date gain of 18.6% as of today's close in the S&P 500 and compare this to the 10% loss that has been posted year-to-date by EEM (all returns exclude dividends). But the volatility characteristics of EEM -- in particular in comparison to those of the S&P -- warrant even closer attention, as illustrated in the accompanying weekly chart of the CBOE Emerging Markets ETF Volatility Index (VXEEM). Like its CBOE Volatility Index (VIX) counterpart relative to the options on the S&P 500 Index, VXEEM is a measure of the average volatility of 30-day options on the iShares MSCI Emerging Markets Index ETF (EEM). (Chart below courtesy of Trade Monster, click to enlarge.)

Weekly Chart of the CBOE Emerging Markets ETF Volatility index Since July 2011

I'll begin with the end in mind here, as not many investors spend too much time examining charts of volatility indices. EEM is a market index that "plays nice" during bull market periods, but is "a very bad boy" in the mayhem that tends to characterize bear markets (or even sharp pullbacks in bull markets). And this "bad behavior" by EEM in weak market environments can cause major indigestion for those investors who've bought Wall Street's emerging markets story, but (please stay tuned) it can also pay off in huge returns for options traders.

And how bad has EEM's volatility been? Very, very bad. There were two separate VXEEM peaks in the second half of 2011 as worldwide markets took major hits – the first at 85 in August 2011 and then another at 86 in October 2011. The corresponding VIX peaks were at 48 and 46, respectively. So during the worst of this particular financial crisis, not only was emerging market volatility almost twice that of the U.S. market, but it exceeded 80% annualized - very similar to the frenetic level of volatility that has accompanied BlackBerry (BBRY) this year as it rallied from $9 to $18 and then plunged back to $9. And most recently, on what many would consider a downside blip in the bull market, VXEEM surged last month to 38, while the VIX topped out below 21. But when the markets were at their quietest in April, the difference between the relatively tame VXEEM (14.71) and the VIX (11.99) was just 2.72 points.

So where, you might ask, is the big profit opportunity for EEM options traders? When EEM volatility is "quiet," an options trade can be constructed to profit enormously, should EEM experience a pullback, while at the same time possessing the potential to profit from an EEM rally. This is possible because EEM option premiums are cheap when EEM volatility is cheap, and: 1. Your leverage from buying EEM call options (the amount you gain compared to your gain from holding the stock) greatly increases and 2. Your leverage from buying EEM put options is even greater, because of the explosive downside volatility EEM has demonstrated and because EEM option premiums soar under those circumstances. But wait, you are buying both a call and a put on EEM? Yes – and when the call and the put each have the same strike price, this trade is known as a straddle. And at Schaeffer's Investment Research, we love the straddle strategy and we are very, very good at it.

All successful straddle traders must have a thorough understanding of volatility-based opportunities such as I just discussed, but at Schaeffer's we look for far more in straddle trade set-ups than buyer-friendly volatility. The ebb and flow of activity of the short sellers, charts whose patterns indicate imminent volatility expansion, the huge increases in option premiums that can occur in the weeks ahead of earnings reports – all these factors and more are on our radar to identify the straddle opportunities with the greatest profit potential - specifically, in our Schaeffer's Volatility Trader (SVT) service.

A quick run-down of just one of our high-profit SVT trades this year? Everyone knows the precious metals ETFs began crashing in earnest in April, but not everyone is aware that volatility on precious metals options had simultaneously gone through the roof, thus sharply curtailing profit potential for option buyers. But back in February, when volatility on iShares Silver Trust (SLV) options was near 52-week lows, we recommended the SLV April 30.5 straddle and we closed this trade in April for a 164% gain. Plus, our risk of a total loss on this (or any) straddle trade was minuscule. For example, if SLV had rallied sufficiently over this same period, our straddle trade would also have shown a profit due to the call position. For more information about Schaeffer's Volatility Trader, please click here.

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