A Great Trade For Those Who Are Patient

The most dangerous thing in finance is the thing that never moves. This stability creates an illusion of control around which many positions are built, the greater the perceived stability the greater the positions and the more other assumptions and forecasts are made.
 
The stability (or lack of volatility) in the Renminbi has been the one of the foundations that has made so many other variables more forecastable. No one can imagine the Renminbi being a highly volatile currency let alone coming remotely close to repeating what happened during the Asian Tiger crisis of 1997! If this foundation of stability goes then there will be a great increase in uncertainty and volatility in many markets across the globe.
 
I don’t know exactly how a breakdown in the Renminbi will play out. However, it is a sure bet that all those markets that prospered over the last 15 years or so on the back of a China will do badly. Where things become shady is the collateral damage to other markets that have had nothing to do with the Chinese economic miracle.
 
I think a reasonable bearish position on the Renminbi will be a great way to hedge out the uncertainty of outcomes with respect to how the Chinese economic miracle “unwinds”.
 
For a long time I have been highly skeptical on the Chinese “economic miracle”. Every contrarian bone in my body has been telling me that there is something not quite right with China’s meteoric rise from an economy that was seemingly insignificant some 15 years ago to the economic powerhouse that we are led to believe it is today.
 
The Chinese economy has risen to prominence too quickly too soon. What has been the driver of this rise? Why did commodity prices explode skywards in 2002 having gone nowhere for the previous 30 years? I find it hard to believe that commodities became scarcer all of a sudden!



Well no one has been able to give me a straight down the line answer - at least one that an ordinary average trader like myself could understand. That is until I came across the following discussion with Mark Hart. Hart came to prominence together with Kyle Bass after shorting the “sub-prime” thing in 2007.
 
Hart’s discussion on China starts at about the 55min mark. Note what Hart says about how he is applying his view on China (via options on the Renminbi). The interview was last month in September. But also note that he has been “bearish” on China at least since 2011!



For more on the issues facing China you might like to read the writings of  Gordon Chang and Michael Pettis . I think both preset very objective views on China.  I am not going to pretend to offer anything more than what these gentlemen offer with respect to the view on China.
 
Hart talks about buying “puts” on the Renminbi. What makes the trade so attractive is the extreme low level of volatility. Here is an index of implied volatility for 12 months to expiry ATM calls on the USDCNY.



So we can buy calls on the USD/Renminbi for about 2.5% vol. For comparison purposes implied volatility on the AUDUSD is about 10%!
 
Hart talks about buying the 7 strike call on the USD/Renminbi. To give you an idea of the leverage offered on a 12-month option at the 7 strike – about $1,100 will get you a notional position of $1,000,000! To achieve a payoff of 10x all the USDCNY would have to close at is 7.07 and at 7.15 a 20x payoff is achieved!
 
One can now appreciate what Mark Hart is on about……..the gearing offered by options on the Renminbi is huge because volatility is grossly underpriced.
 
Is it so crazy to think that the Renminbi cannot get to a “tick or two “ above 7 within 12 months?



Well let’s not forget what happened to currencies in the past. Note what happened to the Mexican Peso during the “Tequila” crisis




The Thai Bhat during the Asian Tiger crisis



The Russian Ruble during the LTCM crisis




Currencies can move and they move significantly when they have been sailing in calm waters for extended periods of time………..just like the Chinese Renminbi now. Position for the unexpected, in effect it is why Hart and Bass made so much money during the Subprime crisis. In our trade alert service we discuss ways in which retail investors can replicate low risk/insanely high reward trades that hedge fund investors like Hart and Bass engage in.