Paul Tudor Jones and Louis Moore Bacon, in a trade used by several hedge-fund managers in the first quarter, loaded up on options that pay off big if Chinese stocks rebound.
Tudor Investment Corp. of Greenwich, Connecticut, and New York-based Moore Capital Management LLC each bought at least 7 million options on the iShares FTSE China 25 Index Fund (FXI) during the quarter ended March 31, according to regulatory filings. Other money managers who used options to bet on or against the FTSE 25 included Philippe Jabre, George Weiss and Brian Stark.
The cost of buying options pegged to Chinese markets has fallen along with volatility there, said Jonathan Masse, senior portfolio manager at Baochuan Capital Management. Investors are exploiting the decline to make low-cost bets that Chinese stocks, having lagged behind those in the U.S. and Europe, will rebound as Beijing concludes a series of interest rate increases designed to check inflation.
“A lot of people are taking advantage of the low volatility to make plays,” said Masse, whose Walnut Creek, California-based hedge fund specializes in China. “There is a big reversion trade expected, where the Chinese markets would catch up in terms of performance.”
FTSE 25 Fund
The FTSE 25, an exchange-traded fund that tracks the 25 largest Chinese stocks on the Hong Kong exchange, includes companies such as China Construction Bank Corp., CNOOC Ltd. and China Mobile Ltd. As of May 20, about 51 percent of its holdings were in financial-services companies, primarily commercial banks, with 24 percent in energy and 17 percent in telecommunications, according to Dan Brown, an analyst with Wells Fargo Advisors LLC in St. Louis.
At least 10 investment advisers running hedge funds reported buying options on 500,000 or more FTSE 25 shares during the first quarter, according to filings this month with the U.S. Securities and Exchange Commission. The managers held options on 44.9 million shares at March 31, up from 4.1 million shares at Dec. 31, including 34.5 million calls and 10.5 million puts.
Call options, which entitle holders to buy a stock at a set price in the future, are used to make bullish wagers, while put options are generally used to profit from or protect against falling markets.
‘Smart Directional Play’
Moore Capital Management, whose main fund has returned about 21 percent annually since 1990, sold almost all of the 2.9 million FTSE 25 shares it held in the first quarter, while buying call options on 8.35 million shares, according to the firm’s 13F filing. Peter Hewer, a spokesman for Moore, declined to comment.
The combination of selling shares and buying call options on the same stock -- known as a replacement trade -- can act as a hedge since losses are limited to the amount paid for the options.
“It’s a smart directional play if you happen to be bullish, because of its risk control,” said Mark Spitznagel, the founder and chief investment officer of Universa Investments LP in Santa Monica, California. Low volatility “creates great low-risk opportunities for people to position themselves long via options.”
Tudor Investment, with about $11.5 billion under management, held call options on 8.54 million shares of the exchange-traded fund at the end of the first quarter, up from 1.2 million shares at Dec. 31, according to its May 13 filing. Patrick Clifford, a spokesman for Tudor, declined to comment.
A Few Bears
Not everyone is using options to make bullish bets. Jabre Capital Partners SA bought 5 million put options on the FTSE 25 fund during the first quarter, according to the Geneva-based firm’s 13F filing, a trade that would profit if the index declines. Ionic Capital Management LLC, a New York-based multistrategy fund founded by former Highbridge executives, bought about 3 million puts during the first quarter, while also adding 2.25 million call options to the 1.25 million it already held, filings show.
Corriente Advisors LLC’s Mark Hart, whose Fort Worth, Texas-based firm made a six-fold gain betting against U.S. subprime mortgages, said May 25 he is using put options to wager on a decline in the yuan, while Jim Chanos, founder of New York’s Kynikos Associates LP, said this week that he would short sell Chinese companies listed in the U.S. if the cost wasn’t so high.
Neither Corriente nor Kynikos owned FTSE 25 shares or options in the first quarter, according to filings.
Flash PMI Declines
The FTSE 25 fund has dropped about 3.3 percent since mid- October, when the Chinese central bank began raising interest rates to combat inflation, stoking investor fears that economic growth would falter. The market sell-off continued this week as China’s preliminary manufacturing index, an economic indicator known as the Flash PMI, declined to 51, inching closer to the level of 50 that suggests the economy is contracting rather than expanding.
The U.S. benchmark Standard & Poor’s 500 Index jumped about 14 percent during the same period, fueled by the Federal Reserve’s efforts to stimulate the economy through low interest rates and the latest round of quantitative easing, known as QE2. China has also done worse than emerging markets overall, as evidenced by the iShares MSCI Emerging Markets ETF, which is up about 4.4 percent since mid-October.
‘Believing in China’
Still, long-term investor sentiment toward China has been turning positive. On May 23, the ratio of put options to call options on the FTSE 25 fell to 0.808, the lowest level since April 2009.
“The call volume is really people still believing in China and feeling it is going to outperform in the latter half of the year,” said Paul Brigandi, co-manager of New York-based Direxion Monthly China Bull 2X, a $9.5 million fund benchmarked to the FTSE 25. “Once inflation is reined in, people go back to focusing on the growth story, the consumer and the rising middle class.”
Weiss Multi-Strategy Advisers LLC, based in Hartford, Connecticut, held call options on 6.1 million FTSE 25 shares at March 31, up from 1.4 million at Dec. 31, according to its May 16 filing. Stark Offshore Management LLC in St. Francis, Wisconsin, bought 4.9 million calls and 2.4 million puts during the first quarter, while New York-based Highbridge Capital Management LLC acquired calls on more than 900,000 FTSE 25 shares, filings show.
‘Pretty Cheap Price’
With call options, investors pay for the right to buy an underlying stock from another investor at a set price in the future. Options on stocks that plunge and soar command higher premiums than those with less volatility.
Option sellers can get lulled into accepting less when markets are placid, providing a potential bargain to those who think historical volatility levels will return. The largest daily price increase in the FTSE 25 index fund last year was 5.5 percent and the biggest decline was 4.6 percent, according to data compiled by Bloomberg. In 2009, the range was a gain of 10.11 percent and drop of 8.5 percent, Bloomberg data show.
“You are bullish on the index for a pretty cheap price because of relatively low volatility,” said Abraham Goodfriend, managing director at Yedid Capital Management LLC, a long-short volatility trader based in Fort Lee, New Jersey.
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