August 24, 2015
Cheap, Hated Market Offers
Huge Income Potential
By Joseph Hogue
Stocks in the world's second-largest economy have been crushed.
Shares trading in Shanghai have lost nearly a third of their value since June, while the sell-off in Hong Kong equities has recently breached the 20% mark used to define a bear market.
But the spike in volatility spells opportunity for options investors. As investor fear mounts in Chinese stocks, so does the premium paid for option contracts. In fact, using one option strategy, we can collect an instant 5.2% cash return and a potential 29.9% annualized gain.
Does the Yuan Devaluation have a Silver Lining?
The recent volatility in Chinese shares is in part due to a historic devaluation of the yuan since Aug. 10. The People's Bank of China (PBOC) has allowed the currency to depreciate approximately 2.7% against the U.S. dollar in a matter of days, an unprecedented rate of decrease.
The PBOC has allowed the yuan to weaken under the guise of allowing greater market influence on its currency. The move could help convince the International Monetary Fund to admit the yuan into its Special Drawing Rights basket of reserve currencies along with the dollar, euro, yen and British pound.
Of course, it doesn't hurt that a weaker currency will make the country's exports cheaper on the international market. Weak exports, which fell 8.3% in July from a year earlier, have been an overhang on the Chinese economy.
The Chinese government has set a GDP growth target of 7% this year and looks to be doing everything possible to meet that target.
The People's Bank is aggressively pumping money into the system after the yuan devaluation led to capital outflows. The PBOC injected 240 billion yuan ($38.4 billion) in repurchase agreements and another 110 billion ($17.6 billion) in bank loans last week.
Economic growth in the second quarter surprised to the upside, matching the government's 7% target on stronger-than-expected growth in fixed-asset investment and industrial output. Some analysts are looking at its economic growth, the slowest since 2009, as if it's the end of the world.
But let's be honest -- economic growth in China is still the highest among large economies around the world. That growth is translating to corporate earnings growth and should drive stock gains. Chinese companies are expected to post earnings growth of 7% this year, below last year's growth, but well above the 1.2% year-over-year growth the S&P 500 reported in the second quarter.
Despite relatively rapid earnings growth expectations, Chinese stocks are trading at 10 times trailing earnings, almost a 50% discount to the 19 multiple on companies in the S&P 500.
Collect a 5.2% Cash Yield, or a 29.9% Annualized Return
iShares China Large-Cap ETF (NYSE: FXI) has plummeted almost 30% since its April high and are back to levels last seen over a year ago. The fund is heavily weighted to financials (50% of holdings), followed by telecommunications (12.5%), energy (11.4%), technology (11%) and industrials (6.8%). I like the overweight to financials, because a lot of the government's stimulus measures have been targeted to increase lending.
The PBOC cut its benchmark lending rate to a record low of 4.85% in late June and lowered the reserve requirement for banks. Hopes for a devaluation-led uptick in exports could drive loan growth and improve the outlook for financials.
With FXI trading at $36.56 per share at the time of this writing, we can buy 100 shares and simultaneously sell FXI Dec 38 Calls, which are trading around $1.90 ($190 per contract). The $190 per contract is yours to keep no matter what and is good for an instant 5.2% return on your cash.
If FXI closes above the $38 strike price at expiration on December 18, our shares will be sold at the strike price. In this case, we will make $3.34 ($38 strike price - $34.66 cost basis) for a profit of 9.6% in four months. That amounts to an annualized 29.9% gain on a fund diversified across 52 companies. I like the trade as long as you can get in for a net cost of $36, which still leaves us with a gain of 5.6% in four months.
Besides the income from the call options, the December expiration means we will receive the dividend distribution that is generally paid in the third week of the month. The distribution hasn't been declared but could add upwards of another 1.5% to our gain. If the shares close below the $38 strike, the options expire worthless and we keep the shares. This would allow us to sell another call option against the position to further lower our cost basis.
My colleague Amber Hestla has been using a similar technique to generate returns of 25.2% in 44 days, 17% in 25 days, 10.7% in 53 days and 7.1% in 36 days. In fact, if you use her technique today, you could collect an extra few hundred dollars by tomorrow. Click here to discover how it works in a brand new tutorialal.
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