This week, I shall cover an ExchangeTraded Fund (ETF) which was in play last Friday and moved 1.53%. ETFs are mutual funds that are traded on a stock exchange, just like a regular stock, and usually track a specialized basket of stocks or index. The ETF I am covering today has gained over 33% in 2009 so far while the S&P500 has gained only 17.5%. This ETF is the iShares MSCI Emerging Markets Index Fund trading under the symbol EEM.
EEM is an exchange traded fund that tracks the MSCI Emerging Market Index. The MSCI Emerging Market Index invests in stocks in global emerging markets such as Russia, India and China. As we all know, the Chinese, Indian and Russian stock markets have recovered ahead of the US stock market with the Shanghai Composite Index gaining over 40%, the Bombay SENSEX gaining over 50% and the Russian RTS Index gaining over 70%. In fact, EEM has received favorable coverage almost every day of last week.
EEM is a relatively young ETF that was listed in May of 2003. EEM went as high as $55.83 before the 2008 global economic crisis, which we are still in, took it all the way to a low of $18.22 in November 2008. Since then, EEM experienced a bumpy first quarter of 2009 before rallying since March 2009 in a steep rally that took EEM over 80% off its November 2008 low to close at $33.24 last Friday.
On the technical front, EEM has been rallying atop a rising 50 day moving average and broke its 200 day moving average decisively earlier this month. It certainly is in a strong intermediate bull trend but is now coming up against its 200 period weekly moving average and 50 period monthly moving average which should provide significant resistance. Volume is also not following into this rally very much, which casts doubt on EEM’s ability to make a resolute breakout of these resistance levels without a pullback. Indeed, EEM sure looks like it is overdue for a pullback but as the old adage goes, the market can stay irrational longer than you can stay solvent.
So, how can options traders profit from EEM with a bullish outlook but being wary of a possible over-extended pullback in the short term?
The beauty of options trading is that you can factor in uncertainty and profit from it. EEM is expected to be bullish with a high possibility of a pullback at about $37, right about where the 200 period weekly moving average and the 50 period monthly moving average are, we could profit in all 3 directions, upwards to $37, stagnant and downwards using a Call Ratio Spread options trading strategy.
Call Ratio Spreads are like the Bull Call Spread that I wrote about two weeks ago on DRYS except that this time, instead of writing an equal number of out of the money call options, the Call Ratio Spread writes more call options than the at the money call options bought. This results in a risk graph with rising profit all the way to the strike price of the short call options and a limited profit no matter how low the stock falls.
In this case, since the pullback is expected to happen in the short term, we could use a 3:1 September 33/37 Call Ratio Spread. What this means is to buy the EEM September $33 strike call options and then write three times as many September $37 strike call options. EEM’s 3:1 September 33/37 Call Ratio Spread is priced at a credit of $0.61 as of last Friday’s close. What this means is that the Call Ratio Spread puts cash into your account instead of taking cash away from your account for putting on the position. In this case, for buying 1 contract of EEM’s September $33 call option and writing 3 contracts of EEM’s September $37 call options, you get $61 before commissions and expenses into your trading account.
So, how will this trade work out?
If EEM continues to rise, the Call Ratio Spread will make its maximum profit when EEM is at $37 during September expiration for a profit of $461 when the 3 contracts of Sep $37 call options expires worthless, making the whole premium of $336 as profit and the long $33 call options profits $125.
If EEM remains stagnant, the long call options would expire with its intrinsic value of $24, losing its extrinsic value of $251 and make as profit on the $336 premium of the short call options, making a net profit of $85.
If EEM should pullback strongly, the position would still make its net credit of $61 as profit no matter how far down EEM pulls back.
Does this mean that there is no way for the Call Ratio Spread to lose money?
The only way a Call Ratio Spread can lose money is for it to rally past the strike price of the short call options to the point where the value of the short call options gain faster than the long call options. In this case, that losing point is at $39.30. Since we expect the resistance level of EEM to be about $37 to $38, we could buy to close the short call options when EEM breaks out and hold on to the long call options to continue riding the rally.
Do you see how options trading gives you a lot more “options” in terms of trading specific outlooks?
For more information, please read my tutorial Call Ratio Spreads .
Lets now take a look on our previous options plays.
DRYS gained 12.19% last week and its Sep 7.5/11 Bull Call Spread is now worth $1.05, which is higher than the debit of $0.90 when we first recommended it two weeks ago. DRYS still has until September to fulfill our $11 expectation of maximum gain on the Bull Call Spread and with all the good news surrounding it the past two weeks, the outlook continues to look good.
MBT opened last Tuesday gapped down at $35.79 and then continued its ride upwards. Even though MBT did not fall below the put option strike price of $35 on the protective put, the protection offered by the put options remain valid until its expiration.