Signal du Jour - FXI - Sharpe 2.04 Win Rate 80%

FXI moved, we didn't.

After a few days in the bond space, we returned to FXI as the underlying had moved quite a bit this week.

The cautious trader would have noted that the slide in FXI this week has challenged our initial position on Monday and may ask if that move is enough to have us reconsider our market views.

The answer is no. We are not interested in direction and the subsequent explanation: for all we know, FXI could have gone down for a lot of different reasons - end-of-month rebalancing, weak economic figures in Asia lately— however, nothing significant to make us think that this doesn’t still present a great opportunity.

At Sharpe Two, we trade volatility and, more specifically, the terminal distribution of the underlying (check out or post on the pros and cons of delta hedging).

Let’s get to it.

The context

When the equity space in the US has been relatively muted this week, equities in China have consistently declined.

The divergence between the two indices started to get pronounced in the middle of this month. We suspect this is the action of fund managers rebalancing their portfolio towards the clear winner this year, SPY, over China stocks.

However, we do not plan to trade one against the other. Instead, we are much more curious about the realized volatility in FXI and decide if something has fundamentally changed.

While the realized volatility (in orange on the chart, using the right axis) is off the year's lows, as one would expect considering the accelerated downtrend in the underlying, we are still far from the highs of the year, when the geopolitical tensions with China were at their peak.

As useful as historical volatility can be to put things in context, it is still a backward-looking indication and has very limited predicting power on the terminal distribution. For it to be meaningful, we need to put it in the context of a forward-looking metric. As options traders, we are in luck; this is exactly what implied volatility is about, and the prices of ATM straddles become particularly useful.

Let’s find out.