Stop me if you’ve heard this one…
“The markets can remain irrational longer than you can remain solvent.”
People usually attribute this bit of wisdom to John Maynard Keynes – and whether he said it or not, it remains as true today as it did in Keynes’ day.
The message here is simple: No matter how right you think you are, the markets have their own agenda.
This irrationality is why no trading strategy is perfect…
Why even the most sophisticated predictive models aren’t able to guess what’ll happen next…
And why our speculative trade on the iShares China Large-Cap ETF didn’t work out as planned.
Let’s take a look…
Anticipating a Beijing Bounce
On January 16, I told subscribers of The Opportunistic Trader to grab the FXI February 16 $22 calls for a limit of $0.96 or better.
So in short, we took a cheap, short-term flier on a bounce in Chinese stocks.
In that alert, I told my readers:
Countless times over the last 12 months, brave buyers of Chinese stock have ventured in, hoping for a bounce. But the bounce never came. They’re all gone at this point, which means now is probably the right time for a small bet on Chinese stocks rebounding.
Well, that lack of buyers didn’t last long.
A week later, the Chinese Sovereign Wealth Fund stepped in as a huge net buyer of stocks. That news – plus a few other levers Beijing had pulled to stem the three-year rout in Chinese equities – should have buoyed our position in FXI.
Here’s the chart I shared on February 9…
iShares China Large-Cap ETF (FXI)
Source: e-Signal
At the time, I noted the RSI trending up and a bullish crossover in the MACD.
Now, I should tell you… this isn’t a slam-dunk setup.
That’s why I kept the trade short (zeroing in on the front-month February 16 options) and cheap (less than $100 per contract). That kept our risk as low as possible.
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This Is Why We Keep Our Risk Low
Unfortunately, even with Beijing pouring money into stocks, the value of our option began to deteriorate rapidly ahead of expiration.
And on February 13, after profits failed to materialize, we cut our losses at around -48%.
Yet the rationale for the trade remains intact.
Take a look…
iShares China Large-Cap ETF (FXI)
Source: e-Signal
The RSI continues to trend up.
The bullish MACD crossover remains in effect.
Further, the 10-day looks poised to cross the 50-day, another bullish indicator.
But while the setup remains, the price has met resistance around $22.60 since mid-January.
Now, you might be asking… why didn’t we just buy an option farther out? Say, the March 15 expiration?
Two reasons:
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Too much risk. The March 15 calls had an additional month of time value, making them too expensive for such a speculative trade.
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“More time” is a double-edged sword. Sure, you get more time for the trade to work in your favor…but more time for the trade to work against you if the markets decide to be irrational.
Now, the rational thing would be for the price to trend up along with the indicators I just mentioned.
But remember, irrationality is a hallmark of the financial markets.
No matter how prepared you might be or how many indicators you have predicting a move, the markets are going to do what they’re going to do.
And sometimes, the only thing you can do is cut your losses and get out of the way.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict