Text size

Pure coincidence or inside information? One of those reasons explains how one investor knew to position bullishly in the options market one day before China's central bank lowered interest rates for the first time since 2008.

The People's Bank of China said Thursday that it was lowering its benchmark interest rate on loans and deposits by 0.25 percentage points. The bank lowered the one-year yuan lending rate to 6.31% from 6.56%, and the one-year yuan deposit rate to 3.25% from 3.5%.

The news surprised many investors, but one was supremely well positioned to benefit from the rate decision. This investor traded 40,000 options on the iShares China FTSE/Xinhua China 25 Index exchange-traded fund (ticker: FXI).

On Wednesday, the investor sold 20,000 July $25 puts on the China ETF when it was at $33.43 and bought 20,000 July $37 calls. The trade generated a credit of two cents per contract. The choice of strike prices implies this investor anticipated the exchange-traded fund would rise 11% by July 20. In recent trading, the July $37 call price was up 83% and the ETF was up 2.8% at $34.44.

In the absence of the rate cut, the trade seems inexplicable. Concern that China's economy was slowing sharply has been one of the major worries of investors all over the world.

That's been reflected in the iShares China FTSE/Xinhua China 25 Index ETF. Year-to-date, the ETF is down 1.43%. In the past month, the ETF dropped 7.6%. In fact, the ETF is down about 20% even as the Standard & Poor's 500 Index gained 4.6%.

The persistent negative returns makes the options strategy used before the rate news even more curious because the risk-reversal strategy was flawlessly constructed to profit from the news.

By selling puts, the investor took advantage of the fear premium baked into the bearish options based on concerns China's economy is slowing sharply. Puts increase in value when associated prices decline. Investors have primarily bought bearish puts—rather than sold them—as Chinese economic indicators, such as its purchasing managers' surveys, have deteriorated.

The purchase of the bullish calls, paid for by selling bearish puts, let the investor benefit from any price advances experienced by the China ETF. The strategy of selling puts and buying calls is a risk-reversal, and few options trades so effectively capitalize on the fear of other investors.

To be sure, the bullish trade went against Wednesday's dominant trading patterns that saw most investors buy bearish puts. While one investor was betting on an advance, others bought blocks of 5,000 January $28 puts on the China ETF in apparent expectation of a decline of 15% or more.

Fu is Chinese for luck. This one China investor could be exceptionally lucky. Of course, anyone who makes big options trades would likely protest any assertion that performance is attributable to luck. Nonetheless, market regulators should review the trade.

Comments: steve.sears@barrons.com

http://twitter.com/sm_sears

Steven Sears is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.