Monday, December 19, 2011

EWY: Buy on the Cannons

The Napoleonic-era financier Nathan Rothschild, whose wealth and power were sufficient to make Warren Buffet look like a homeless waif, said this in 1810: "Buy to the sound of cannons, sell to the sound of trumpets". 

The death of Dear Leader Kim Jung Il in North Korea certainly provides the cannons, or at least the South Korean market is trading it that way.

The price of EWY, the exchange-traded fund that tracks the Seoul exchange, gapped down 3% at Monday's open, and has set a lower low in each of the four hours of trading so far, for a 4.5% decline.

So, hearing cannons, I added EWY to my covered call portfolio for January, one of the very few story plays that I've done in recent years.

A foolish play? I think not. Here's my argument:

If I thought South Korea were in danger of immediate and overwhelming attack from the north, then it would be a too much risk to embrace. But I don't think an attack is likely, because the Americans have reaffirmed their support for South Korea, and the south has the power to inflict overwhelming damage on the north in the event of an attack.

The fact is that a general attack on South Korea and the United States would destroy the North Korean regime, and the Kim Family has above all been protective of its governing legacy. It's sort of a basic family value for those guys.

So, mid-term, I think EWY prices will recover, as it becomes clear that no general war is in the picture.

Short term, perhaps the decline will continue. If that happens, then I have a readily available hedge available. EWY carries very liquid options, with open interest on at-the-money puts of more than 10,000 contracts. Even at-the-money calls -- not favored at this point -- have open interest of more than 1,000 contracts.

If prices continue to decline in Asian trading, then I'll hedge my covered call position by buying puts. 

And if I hear trumpets, if significant upside momentum develops, then I'll buy some calls to turbo-charge my profits.


In line with my bearish opinion of the markets,  I've concluded that this is not a good time for buying covered calls. The stocks in my December holdings all fell, leaving the calls to expire unexercised.

So I'm retaining those stocks -- DDS, GDX, LVS and RIMM -- in order to sell new calls against them, and with EWY added to the portfolio, that's five covered call positions altogether. But I don't plan to add any more, and have put a significant portion of my conservative money (as opposed to my speculative money) into long-term U.S. Treasuries (the exchange-traded fund TLT).

Bottom Line: I opened a covered call position on EWY today.

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