China Options Show Biggest Risk of Stock Drop in Year (Update1) Share Business Exchange

By Michael Patterson and Jeff Kearns



Feb. 19 (Bloomberg) -- Options traders are paying the most to protect against a drop in Chinese stocks since the depths of last year’s global financial crisis as policy makers in Beijing take steps to cool economic growth.



The gap between the implied volatility of options betting on a decline in the iShares FTSE/Xinhua China 25 Index Fund and those that would profit from a gain widened to 7.4 on Feb. 17, the biggest since March, and was at 6.9 yesterday, according to data compiled by Bloomberg. Implied volatility is a measure of expected stock swings and the key gauge of options prices.



The exchange-traded fund, which holds shares of Chinese companies and trades on U.S. bourses, has dropped 14 percent from its 2009 high on Nov. 16 as the People’s Bank of China ordered lenders to set aside larger reserves in a bid to cool inflation in the fastest-growing major economy. Investors are also concerned that China may let its currency strengthen, making exporters less competitive, according to AlphaShares LLC.



“There’s a lot of anxiety about how policy makers keep increasing the reserve ratio for banks and what a strengthening yuan would do to the giant export machine,” said Jonathan Masse, who helps oversee about $480 million in Chinese stocks at Walnut Creek, California-based AlphaShares, the fund company co- founded by Princeton University economist Burton Malkiel.



The FTSE/Xinhua China 25 Index tumbled 3.1 percent as of 8:30 a.m. in London after the U.S. Federal Reserve unexpectedly raised its discount rate, heightening concern that tighter monetary policy around the world will slow the global economic recovery. The iShares ETF tracks the FTSE/Xinhua China 25 Index.



Put Options



Options granting the right to sell the ETF in three months for 10 percent below current prices have a so-called implied volatility of 35.35, compared with 28.42 for the equivalent options to buy, Bloomberg data show. The last time the gap was this wide, global equities were falling to six-year lows on concern bank losses would spur a repeat of the Great Depression.



The ETF’s most-traded option yesterday was a put giving the right to sell shares at $35 by May 21. The fund climbed 1 cent to close at $39.71 in New York trading yesterday. Options linked to the ETF had the 27th highest volume last year for all indexes and equities, according to data from the Options Clearing Corp.



The open interest, or number of existing contracts, for all puts has risen 8.8 percent in the last week to 1.43 million, the highest level since November. Open interest for call options giving the right to purchase the ETF has increased 4.4 percent to 660,141.



‘Outsized Demand’



The largest open interest increase during the past two weeks was for the May $28 puts, which surged 23-fold to 34,214, according to data compiled by Trade Alert LLC, a New York-based provider of option market analytics. The number of May $27 puts rose 68 percent to 38,748 for the second-biggest increase. The ETF hasn’t closed below $37 since July.



“There’s been outsized demand for downside puts,” said Justin Golden, a strategist at New York-based Macro Risk Advisors LLC, which advises institutions on equity derivatives. “This is related to a heightened degree of uncertainty around the speed at which China will tighten policy in addition to the potential for a currency revaluation at some point in the near future.”



China’s central bank said on Feb. 12 that it will lift reserve requirements for banks for the second time this year on Feb. 25. Policy makers are reining in credit growth after banks extended 19 percent of this year’s 7.5 trillion yuan ($1.1 trillion) lending target in January and property prices climbed the most in 21 months.



Currency Bets



China may let its currency appreciate by 5 percent as early as next month to prevent economic growth from stoking inflation, Stephen Jen of BlueGold Capital Management LLP said in an interview this week. Goldman Sachs Group Inc. Chief Economist Jim O’Neill said this month that a decision by China to revalue the currency as much as 5 percent “could happen at any time.”



China has controlled the yuan’s exchange rate since July 2008 by buying U.S. currency, keeping it at about 6.83 per dollar. China’s “first challenge is inflation expectations,” People’s Bank of China Deputy Governor Zhu Min said on Jan. 30.



The China ETF holds shares of 25 Chinese companies including China Mobile Ltd., the world’s largest phone carrier; Industrial & Commercial Bank of China Ltd., the biggest lender by market value; and Aluminum Corp. of China Ltd., the nation’s biggest producer of the metal.



“As investors seek a general market downside protection, FXI put options become a favored choice,” said Rebecca Cheong, an equity derivatives strategist at Societe Generale SA in New York, referring to the ETF’s stock ticker. “Our desk has seen consistent FXI put buying flow the last few weeks.”



To contact the reporters on this story: Michael Patterson in London at mpatterson10@bloomberg.net; Jeff Kearns in New York at jkearns3@bloomberg.net.