Options Traders Target Emerging Markets as U.S.-China Talks Sour

(Bloomberg) -- Casting aside the relative calm seen earlier this the week, options traders are all of a sudden catching on to the risk that emerging markets will be in the crosshairs if a trade war escalates -- and other asset classes would be collateral damage.

The hours that followed the opening of U.S. markets Thursday saw a rush for protection in segments of the derivatives market most sensitive to the U.S.-China trade tiff. Those assets had been well-behaved in the days prior amid bets that a deal would eventually get done despite the heated rhetoric from U.S. negotiators and President Donald Trump.

“While we think risk is still tilted to the downside ahead of tomorrow’s tariff deadline, the situation is fast-moving and we could be one tweet away from a major reversal,’’ said Mandy Xu, chief equity derivatives strategist at Credit Suisse.

Bets that the Chinese yuan will weaken relative to the dollar over the next week, judging by one-week, 25-delta risk reversals, have spiked to their highest level since February 2016, when memories of the prior year’s shock devaluation of the currency were still front-of-mind. Goldman Sachs has previously noted that a weaker currency could help China offset the effects of U.S. tariffs.

Options Traders Target Emerging Markets as U.S.-China Talks Sour

Meanwhile, implied volatility for emerging-market stocks is on track for its biggest one-week increase relative to similar contracts on U.S. small-cap stocks since Trump won the presidential election, signaling that investors are seeking long-term insurance against trade-related woes. That’s a major turnaround from Tuesday morning, when the spread between the Cboe Emerging Markets ETF Volatility Index and its U.S. equivalent was actually lower on the week even as developing-market equities underperformed.

Options Traders Target Emerging Markets as U.S.-China Talks Sour

Emerging-market equity skew -- a measure of demand for protection relative to bets on upside in the options market -- has spiked to its highest level since the middle of 2018, when China’s retaliation to the initial bout of U.S. tariffs was kicking in and Trump vowed that additional levies would follow.

At the same time, the implied volatility of one-month puts that pay off if emerging market equities fall 10 percent from its current level has soared compared to the cost for calls that would pay out if the gauge rises 5 percent in that time.

Options Traders Target Emerging Markets as U.S.-China Talks Sour

Credit Suisse’s Xu recommends investors position for further downside in emerging markets.

“We like put spreads in this high vol, steep skew environment,’’ she wrote in a note to clients, suggesting a trade that benefits from the iShares MSCI Emerging Markets ETF falling between 4.5% and 8% over the next month.

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