Signal du Jour - Sharpe ratio 1.91 Win Rate 89%
Shorting vol is no easy business when you don't have a plan
While the US equity markets are soaring, their counterparts in Asia have faced a tougher start to the year.
As highlighted in yesterday's Forward Note, Chinese stocks have taken a 7% hit, burdened by dim economic prospects and a seemingly unsolvable real estate crisis.
But here's the silver lining for us volatility traders: market movements often spell opportunities. While we remain hopeful for overall stability in Asia, the upcoming Chinese New Year celebrations should bring a cooler period for the equity markets. This leads us to consider a short volatility position in EWH, an ETF focused on Hong Kong stocks.
Let's dive in.
The context
The decision by China to abandon its stringent COVID policies about a year ago was expected to ignite an economic boom, fueling global growth and rejuvenating the stock market after a challenging period.
Initially, there was a brief period of economic optimism, but it didn't last long. The reality soon set in: economic conditions remained sluggish, with particularly worrying unemployment data emerging. In a move that raised eyebrows, the government abruptly ceased publishing youth unemployment statistics – such lack of transparency is rarely seen as a positive indicator.
Though Hong Kong's economy is somewhat distinct from mainland China, the Hang Seng Index (HSI) has still endured a turbulent year.
This graph highlights the strong correlation between FXI (a China-focused ETF) and EWH (tracking Hong Kong stocks), hinting at potential opportunities for pair traders. (Thorough analysis should be conducted before making any trading decisions.)
From this data, we can infer that the realized volatility in EWH has been incrementally increasing as the index trends downward.
Indeed, barring any dramatic surges, realized volatility in EWH is at some of its highest levels, aside from the significant spikes at the end of 2022 and early 2023. Those earlier peaks coincided with a different market regime as investors celebrated the easing of pandemic restrictions.
This ongoing high volatility scenario is likely causing concern for investors compelled to maintain holdings in Hong Kong stocks, either due to regional commitments or portfolio mandates.
Faced with such market conditions, what's a prudent investor to do? The logical move is to hedge. And we suspect this heightened demand for protection is skewing the pricing of options, potentially creating lucrative opportunities for those looking to sell volatility.
Let's see what the data reveals.
The data and the trade methodology
Feeling a bit uneasy after the previous section? That's completely normal.
Selling premium in a market with a downward trend and uncertain economic outlook is not for the faint-hearted. But remember, you're offering a valuable service to the market, and it should be worth your while. Let’s validate this hypothesis with a thorough analysis of straddle prices.
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