Monday, June 1st, 2020

Options in a Chinese Bear Market


The Chinese stock bubble is bursting. How do you trade options in a Chinese bear market? CNBC writes that Chinese stocks could slide 50 percent.

A bubble in Chinese stocks is bursting and the market is likely to halve in value from current levels, one strategist told CNBC on Thursday.

The benchmark Shanghai stock index slid more than 3 percent on Thursday to 4,528, highlighting the frail state of a stock market that plunged 13 percent last week.

But even after the correction, the Chinese stock market is up some 40 percent this year alone, boosted by heavy investment by retail investors and monetary easing from China’s central bank.

“We’re cautious on Chinese equities, which we think is a bubble which is bursting real-time here,” Stewart Richardson, chief investment officer at RMG Wealth Management, said on CNBC’s “Worldwide Exchange.”

If this is not a simple correction and the Chinese market continues to decline, how do you trade options in a Chinese bear market? The best bet is probably to trade options on American Depository Receipts of Chinese stocks. The volatility might not be the same as when trading in Hong Kong or Shanghai but you will have the transparency that comes with trading in a US market on your side.

How Far Down?

The commentator for CNBC thinks that a fifty percent fall is entirely possible. If you are going to trade options in a Chinese bear market you need have a clear idea as to whether the market has made its correction or is going do decline even farther. One of the worrying aspects of the recent Chinese bull market was the degree of over-leveraging. Way too many people appeared to have been trading on margin. Fortune comments of the margin calls the accompanied the recent twenty percent drop in the market.

The Shanghai index rose almost 100 points to 4,276 in the first few minutes of trading. Analysts agreed that the central bank was telling investors it didn’t want to see panic selling following a manic 150% rise in Chinese stocks over the last year, which started when the country’s state-owned press began touting stocks to the country’s small investors.

But eight minutes after the open, around 9:38 a.m., the sellers took over and Chinese markets later slipped into traditional bear market territory (a 20% decline from peaks) for the first time since 2010.

Today’s continued fall wasn’t unexpected. Steven Sun, HSBC’s head of Hong Kong and China equity research, said the reduction in margin financing is behind the rout in stocks, as leveraged traders furiously try to cut their exposure.

Chinese stock valuations are way too high. Many real estate investors bailed out of real estate in the last year and piled into stocks. The flood of retail investors accustomed to continual growth in China has led to highly leveraged positions and, now, traders who are losing everything in margin calls. If this situation compounds itself the only reasonable options in a Chinese bear market will be puts.

Market Sickness

With a state controlled economy and state owned banks financing state owned companies many have believed that the Chinese economy is immune from the damage of a stock market crash. However, in the last year or so, companies have started to rely more heavily on selling stocks to raise money than taking on debt. In this sense market sickness could infect the Chinese economy as The Wall Street Journal reports.

It would be a mistake, however, to assume that China will shrug off this market meltdown. For one thing, hectic activity at brokerages and trading firms has been a direct support to an otherwise sluggish economy. According to research firm Capital Economics, this alone boosted the economic growth rate by half a percentage point in the first quarter, when GDP was up 7% from a year earlier. Losing this support could cut a full percentage point off the annual growth rate, Capital Economics estimates.

With a Chinese economy that is more connected to the market there is more risk of a continued bear market and more reason to hedge against loss and look for gains on the put side.

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