How to Invest in China with LEAP Options

10/26/2009 10:26 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

International stocks are significantly correlated. Stocks around the globe tend to go up and down together at the same time. If US stocks are rising, then international stocks tend to follow, but they may not run at the same pace. Quite often, emerging economies run ahead of US stocks. This article will discuss why options may be a great way to leverage growth opportunities and diversify into fast-growing emerging economies.

Among emerging market funds, those concentrating on the "BRIC" economies are the most popular. BRIC stands for Brazil, Russia, India, and China. Sometimes an emerging market fund may also supplement BRIC investments with stocks from places like Turkey, Mexico, and South Africa as well. Just as we might expect small cap stocks to outperform large cap stocks in a bull market, the growth potential is higher in emerging markets than within larger more established economies like the US, UK, or Western Europe.

The other side to this equation is that greater risks always accompany greater profit opportunities. For example, during the 2007-2009 US stock market crash, the S&P 500 was down 60%, but Chinese stock ETFs were down 73%. However, keep in mind that during the rally from March through July of 2009, US stocks are up 42%, while Chinese stock ETFs are up 80%. The increased volatility in international stocks is bad on the way down, but can be a big benefit on the way up.

The potential upside is what attracts investors to international stocks like this, and long-term options may be one way to avoid the value trap when prices decline suddenly. A value trap happens when share prices are dropping quickly and traders are faced with the dilemma of holding the shares and hoping prices come back or selling the shares and recognizing the loss.

The value trap is powerful because traders often don't know what their maximum loss could be. If an ETF costs $100 per share, they could theoretically lose a maximum of $100 if prices collapse. Alternatively, an option buyer knows that the maximum loss in a trade is the premium paid for the option. In absolute dollar terms, this is usually much smaller than a stock purchase.

Long-term investors will often utilize LEAP calls for this kind of play. If the market rises, they will make a higher percentage profit than an investor holding the stock and they have a lower maximum loss in dollar terms to the downside. This combination of benefits can be a nice fit for traders evaluating a volatile position like emerging market stocks.

For example, imagine that you are evaluating a long position on FXI, which is an exchange traded fund that invests in Chinese stocks. The shares are available for $41.16 and you believe the stock will rise another $20 over the next year and a half. You could buy the stock or potentially invest in a LEAP call for the same reason. If you select the LEAP option, the at-the-money strike is $40 and a call that expires in 18 months costs $8.20 per share or $820 per contract.

Potential Outcome #1: Stock Rises $20 to $61.16 in 18 Months

LEAP call is worth $21.16 per share for a 158% gain
Stock is worth $61.16 for a 50% gain

Potential Outcome #2: Stock Falls $20 in 18 Months

LEAP call is worth nothing for a max loss of $8.20
Stock is worth $20 for a loss of $21.16

The example above is biased because if the stock remains flat, the stock buyer will outperform the options trader who may still lose their entire investment if the market stays below $40. However, an investor may consider historical volatility as an indication that this outcome is unlikely.

Like all investing decisions, ultimately it comes down to the investor's ability to forecast market direction. An option investment may be a great alternative for volatile stocks and a long-term LEAP contract is a great way to make sure there is plenty of time for an ETF like this to move.

Watch the video below for more information:

By John Jagerson of LearningMarkets.com.

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