EEM - EEM: Only Short This ETF With Caution

Summary

• High short interest means plenty of speculators are short iShares MSCI Emerging Markets ETF.
• However, EEM shares continue to make higher highs on the long-term chart.
• Therefore, to control risk, defined risk put spreads are our preferred strategy to trade iShares MSCI Emerging Markets ETF.

Intro

If we pull up a chart of iShares MSCI Emerging Markets ETF (EEM), we can see that shares look like they are finally turning over after 3 months more or less of rising prices. Long-term exchange-traded fund ("ETF") investors may actually believe that this pending downturn is overdue given the fund's lofty expense ratio of 0.69% and very high short interest of 21%+.

High short -interest ratios are basically non-existent in ETFs, which means EEM basically sticks out like a sore thumb with respect to how bearish speculators are in this fund. The high short-interest ratio should not be underestimated, as short-sellers are sophisticated speculators in that many times their due diligence (due to the risk they are taking) needs to be far more comprehensive than long-only investors.

Put Debit Spread

Following on from this and given the fund's strong option liquidity (465k) and low IV rank (11), the play here from a strategy standpoint (using options) would be something like a bear put debit spread once a sell signal is confirmed. We normally set up our debit spreads by wrapping both our long and short strikes around the prevailing share price of the stock/ETF. In EEM's case (with shares of the fund currently trading at $41.36), the purchase of the regular March long put debit spread (purchase of the $43 put & sale of the corresponding $41 put option) comes in at $1.06 per debit spread. Given the extra extrinsic value in the $43 put, the breakeven point for this strategy comes in at $41.94. This means the odds are above 50% that the trader will make a profit in this play.

The above example essentially shows that the trader is risking $106 per debit spread to make a possible $94. This means (as opposed to shorting a stock or buying puts outright), the potential reward of the strategy is defined. The answer to why we would favor spreads and define our risk over naked options lies in two areas.

Long-Term Bull Market

As we see below, EEM has been making higher lows and higher highs for over seven years now. Why is this significant? Because the amount of information in the chart below is significantly greater in quantity than the information in the daily chart above. Suffice it to say, aggressive short-term trading or investing should always be in alignment with the long-term trend. Therefore, taking into account the discrepancy between the two charts, the debit spread (Considering the defined risk makeup of the put debit spread) makes more sense to us compared to just buying put options outright. If shares were to rebound significantly to the upside, for example, the debit spread strategy would lose value at a far slower clip compared to the naked put alternative.

Weakening Dollar & Low Fund Valuation

Furthermore, we believe the U.S. dollar printed a multi-year top in September of last year. This means there is plenty of runway for emerging market currencies (and associated funds) to keep on strengthening against the greenback. We have already seen from history how a weakening dollar has benefited emerging market companies due to their local currencies being much stronger in relative terms.

Then you have EEM's valuation. The fund at present trades with a book multiple of 1.71 and an earnings multiple of 12.28. These multiples continue to trail valuations in the west by a considerable margin and carry less risk for the following reason. If you take an ETF that tracks the S&P 500 such as (SPY), we can see that this fund trades with a book multiple of 4.01 and an earnings multiple of 19.76. The higher multiples (Especially on the assets side) imply a higher forward-looking growth rate. Nevertheless, if SPY's projected growth rate is not realized, SPX would fall much further than EEM in percentage terms, all things remaining equal.

Conclusion

Therefore, to sum up, if iShares MSCI Emerging Markets ETF's 5-day moving average drops below its corresponding 20-day, we may look to put debit put spreads to work in anticipation of a downward move. However, EEM's keen valuation, higher highs, and higher lows on the technical chart as well as the sustained weakness in the greenback we have seen in recent months demonstrate to us that the smart money continues to be long in iShares MSCI Emerging Markets ETF. We look forward to continued coverage.

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