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By: Chris Rowe — June 29, 2009

It's the Strongest Market in a Global Meltdown: Hedging China, Selling the Rest. Here's Why...

First, things first.  Rest in peace to all four megastars who passed away in the last week:

1. Michael Jackson (I know people have mixed (or very clear) feelings about him. The great achievements, though, were as great as can possibly be.)
2. Ed McMahon (whom I knew briefly)
3. Farrah Fawcett
4. Billy Mays

Back to Business...

Reading The Tycoon Report regularly is the best way to know when to buy (low) as the rest of the world is panicking, or sell (high) just as the world is just a little too confident -- like now.  Navigating these waters alone can be incredibly daunting. 

Don't worry -- we've got your back!

Last week, after witnessing -- for the second time this year -- supply taking control of the stock market, I told you to exit or hedge bullish positions, and get bearish.  If you get aggressively bearish, your odds of making huge profits are pretty damn high right now.

But you have to be careful about where you get aggressively bearish, as opposed to what you simply HEDGE. 

'Hating on' China

I wonder how many Tycoon Report readers know what it means to be a "hater."  (Hater = jealous person. To hate, or "hating" = the act of being jealous.) 

And I wonder how many global economies are currently sipping on the "Haterade," knowing the World Bank just raised China's growth forecast from 6.5% to 7.2%, after seeing signs that the economy is doing much better than expected.  In fact, the World Bank even advised policy-makers to delay any additional stimulus plan until 2010 because it's just not necessary! 

"Forget about the need to boost the world’s third-largest economy?  What!?  But I just read that exports slid for a seventh month in May, declining by a record 26.4% from a year earlier!"

Remember late last year (I wrote about it), when China announced a 4-trillion-yuan ($585 billion) stimulus package?  Well, it triggered surging investment and record loans. And while exports slid because of the global recession, the World Bank said it's "not necessary, and probably not appropriate" for China to add fiscal stimulus this year. 

Talk about saving for a rainy day -- and being rewarded.

Now, let's not confuse what my point is here.  The supply side has also taken control of the Chinese stock market, just like the U.S. stock market. 

Gravity doesn't only apply to the U.S. market; it applies to China as well.  But the strength in the two markets just doesn't compare. 

China's a situation where long-term bullish investors should consider hedging bullish positions as opposed to getting outright bearish

There are Many Ways to Hedge Bullish Positions

Here are some strategies through which you can use options to protect your current profits:

1. Buy Protective Puts -- This is a debit trade -- "portfolio insurance" -- that is, paying for the right to sell the stock or Exchange-Traded Fund (ETF) at the "strike price."  Not my favorite way to hedge.  In fact, this strategy is a "synthetic call" because it has the same risks and rewards as owning a call option.

2. Sell Covered Calls -- or, if you own long calls instead of the underlying securities, you can create a diagonal call spread. This is a credit trade -- you collect a premium in exchange for a promise to sell stock or ETF at the "strike price" (or, exercise price) of the option. 

One of my favorite strategies is the option trader's version: the diagonal call spread (aka, calendar spread).  This works well, especially when you "roll as you go."  Whether it's covered calls, or a diagonal call spread, it makes sense to write/short-sell the at-the-money, or slightly out-of-the-money, call option and adjust the position as needed.

3. Use an Equity Collar -- This is a combination of 1 and 2. Sell covered calls, collect premium -- and use the premium to buy puts.  This is good for those who don't want to exit the bullish stock or ETF position.

This might be done for tax reasons, or some other odd reason.  But you limit or eliminate your downside, while allowing yourself minimal upside.

4. Stay bullish on those long China positions, and buy deep-in-the-money puts on other, weak, securities that are members of relatively weaker stock markets.

5. A combination of 1-4

Different Strokes...

The World Bank, Goldman Sachs and the International Monetary Fund (IMF) are calling for negative growth, globally, for the first time in six decades. 

The U.S. economy shrank at an annual pace of 5.5% in the first quarter, the second-largest quarterly drop in 27 years.  And many investors are used to focusing on their own country's markets. 

As I said, China looks much different than the U.S. markets, both economically and as a marketplace. (China's GDP grew 6.1% in the first quarter, and the World Bank just raised China's growth forecast from 6.5% to 7.2%.) 

And, sure, the World Bank can be wrong -- it's not always right -- but markets speak louder than words!

Just look at this chart that looks a LOT different than most global markets.  It's the one-year chart of the Shanghai Composite Index, which -- forget about the September high before the world markets collapsed -- has actually gained back everything it's lost since the July 2008 high!

 

The S&P 500 still has to gain more than 36% to reach its July 2008 highs. 

A Bull on China Stock
s

Just based on the strength of the Chinese stock market, we have to remember that the very long-term picture of China offers the biggest profit opportunities on the map.  That's why, when you see a global slowdown or a global market sell-off, China is the place to shop for the super long-term holdings

You might remember the five articles I wrote over the two months when the global markets were bottoming out (Oct. 28, 2008, to Dec. 2, 2008 -- links to these articles appear at the end of this one), when I stepped out of my typical shell and started talking about opportunities in Chinese stocks and ETFs. 

(I had to share some of these ideas -- even though I typically reserve all trading recommendations for members of The Trend Rider -- given the historic opportunities presented to us at the time). 

Check out the returns (average return: 96.48%)...

Stock or ETF
Date of rec. Price Today's Price Gain
CNOOC (Sym: CEO) 10/28/08 $56.00 $126.01 125.00%
PetroChina Company (Sym: PTR) 10/28/08 $57.00 $113.78  99.62%
China Life Ins. Co. (Sym: LFC) 10/28/08 $33.47 $55.95  67.17%
New Oriental Ed (Sym: EDU) 11/18/08 $55.46 $65.34  17.82%
American Dairy Inc. (Sym: ADY) 11/18/08 $14.45 $41.44 187.79%
Focus Media (Sym: FMCN) 11/25/08 $6.90 $8.01   16.08%
Baidu (Sym: BIDU) 11/25/08 $115.13 $298.18 158.99%
iShares Singapore (Sym: EWS) 12/2/08 $6.18 $9.09   47.08%
iShares Hong Kong (Sym: EWH) 12/2/08 $9.45 $14.06   48.78%

I focused on these Chinese stocks and ETFs for the same reason I'm writing this article today: I want to point out the strength in a market that's unmatchable. 

Those articles highlighted the strength as a reason to buy, but today's article highlights the strength as a reason to hedge (as opposed to getting bearish). 

The supply side has taken control (as of now), and, until further notice, you're probably about to see a sell-off in the Shanghai Composite just like the other global markets.  But China might be the area to either hedge or reduce your bullish positions instead of getting aggressively bearish. 

I'm still just as bullish on China over the "very long-term" (10-15 years).  But the global economy is still slowing, and consumption in China is going to slow down; this will cause lower employment and possibly wages. And while GDP grew 6.1% in the first quarter of 2009 from a year earlier, that was the the least it grew in the last decade.

The Chinese market can and probably will pull back, and it can pull back hard.  But as a very long-term holder, that's definitely something that's tolerable, as long as you hedge when necessary. In terms of the strength, relative to other global markets, China is a force to be reckoned with. 

Let's look at a three-year chart. 

You can see that the market has huge gains and huge declines.  But you've got to respect the strength in the Shanghai market (and economy).  When they're up, they're up big, and vice-versa. 

I told you by buying China very-long term, you're buying the United States in the early 1900s or earlier and that their market and economy will remain volatile for a long time. When the global economy was booming (on corroded stilts) in 2007, China was the single-largest contributor to global growth (19.5%).  

So that's what you need to know.  Odds favor a decline in just about all global markets right now.  Of course that can change, but right now, we're seeing almost all of the signs of a market about to take a quick dive.  But the takeaway here is to not judge the stocks of all global markets in the same way. 

Sure, maybe the World Bank is advising China that it doesn't even need any additional stimulus, and to save it in case it's needed in 2010. But here in the United States, we don't yet know what the impact will be on our GDP as a result of the passing of "the pitchman" Billy Mays (rest his soul).  How much less revenue will the U.S. do now???

Feel free to read any of the articles I wrote, including detailed assessments of the Chinese stock and ETFs.  (I pretty much picked the exact bottom in the Shanghai Index with the trading ideas discussed below):

Oct. 28, 2008
Sleeping Giants: 3 Chinese Stocks to Buy

Nov. 11, 2008
Sleeping Giants, Cont.: How to Get Rich in China

Nov. 18, 2008
More Sleeping Giants: 2 Chinese Stocks to Buy

Nov. 25, 2008
2 Chinese Stocks Set to Multiply 20 Times Over

Dec. 2, 2008
1,000% Profits with Two Asia ETFs

Feel free to check out everything I've ever said to you about the stock market, and when I said it, by visiting this link

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