ETF EEM: Be a Contrarian by Selling Sell Ratio Spreads (NYSEARCA:EEM)

Vladimir Zakharov

Introduction

We wrote about iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) in March of this year, when we recommended a neutral delta choke due to the fund’s high levels of implied volatility at time. Although the ETF has lost around 19% over the past 6+ months, selling chokes would have been a good play in EEM, given that the position could have been defended by rolling the put side of the choke, both on strike and out. time over time.

Before we get to how we view EEM now from a strategic perspective, let’s take a look at the technical chart to see where the fund currently stands. Suffice it to say that the fund (demonstrated by the falling long-term histogram as well as the RSI momentum indicator), hasn’t been this oversold since 2008, which is telling in itself. That said, we are still a long way from a bullish cross on the MACD indicator, although stocks are now coming up against very strong downside resistance that dates back to 2008. This means trend followers due to the trend Sustained highs and lower lows remain bearish in this fund.

EEM is now coming up against strong bottom support

EEM Technical Charter (Stockcharts.com)

Bearish Sentiment

The bearish sentiment can be confirmed by the rise in short interest (13%+) in the fund and the high level of implied volatility (25%+) as we can see below. Both of these parameters are well above standard norms for EEM and denote high risk for the seasoned ETF investor.

However, when sentiment is at its extreme, there is always an opportunity for the opposite if one has the courage to go against the grain. On the one hand, we have this multi-year lower support, which should at the very least slow down the sustained pattern of lower lows we’ve been seeing for months now. For a maverick, that might be all you need. Let me explain.

Iv v HV (<a href=

EEM Implied Volatility v Historical (Interactive brokers)

Volatility is still high near lows

When you’re selling options for a short period of time (like 2 months), time or theta decay really works in your favor. In fact, given where implied volatility currently sits in the EEM and how well this fund has tracked SPY, a broad bottom in equity markets, in general, will most likely cause volatility to contract which again favors the seller of options as one could profit not only from theta but also from vega.

Another way to take advantage of EEM’s current setup is to take advantage of the fund’s selling bias. When there is more fear on the downside, a delta 30 put for example will be richer in premium than a corresponding delta 30 call option. Therefore, since puts the trade richer than calls, which means call spreads are trading richer than their corresponding sell spreads, some indefinite risk options strategies to consider would be a naked put, a jade lizard (combination of a naked out-of-the-money put option with an out-of-the-money call spread), or a ratio. After evaluating the three options, we believe the ratio spread is the best choice for the following reason.

Report deviation

While I’m sure there will be options traders who can opt for the Jade Lizard as it is also a high profit probability setup, we prefer to be directional in EEM at this time. The worst-case scenario of the three strategies is defending a naked put option. This is not a problem from a risk perspective because given the degree of diversification and the holdings that make up EEM, we can just drop in and out until we can finally make a profit.

Diversification of ESEE

Breakdown of EEM holdings (Looking for Alpha)

With the allocation of ratios, however, we can get the lowest cost basis, which is essential. Remember that the sell spread is made up of a long bearish sell spread and a short sell spread. As we can see below, given the low cost of the put spread (which could fetch $100 if the trade goes against us) and the wealth of the $34 naked put, we can significantly reduce our base of costs relative to where the shares are currently trading.

Current EEM price $35.92
Long November $35/$34 put spread cost (debit) +$26
$34 Short Sale Option (Credit) -$58
Cost Spread Ratio (Credit) -$32
Breakeven point on trade (cost basis) $32.68
Probability of profit 86%

Conclusion

Although the EEM has been absolutely hammered over the past few sessions, we would caution against a neutral delta strategy here in the event of a violent reversal to the upside. We believe selling a ratio spread is the fund’s best strategy at this time. We look forward to continued coverage.

Sallie R. Loera