Sweet Redemption: How My China Put Strategy Worked To Perfection by Jake Huneycutt
Alas, it has taken several years, but I have my sweet redemption. My China put option strategy has worked to perfection in 2015. Unfortunately, however, I never got to see it through. I got sacked a year too early after I experienced a run about 10 months of underperformance.
The origins of the strategy go all the way back to 2010. It was that year that I first encountered one of the world’s most famous short-sellers: Jim Chanos. Chanos was appearing all over the media talking about the Chinese Asset Bubble. In the investment world, there’s a lot of hyperbole out there and you have to learn to ignore most of it. As it turns out, gold did not go to 10000, the US did not experience hyperinflation, and the Yuan has not replaced the Dollar as the world’s reserve currency. It would be easy to dismiss Chanos’ grand claim that China was Dubai times 1,000, as well. Yet, Chanos’ argument made a lot of sense.
I was a neophyte Portfolio Manager at the time. I had gotten my start by aggressively buying into the depressed markets of late 2008 and early 2009. In late 2008, I focused on buying into commodity producers. In early 2009, I shifted towards the REITs and was finding deep bargains in that sector. I ended 2009 up over 100% in my personal portfolio.
After writing a series of articles on the REITs from early to mid 2009, I started managing a long / short portfolio for an ultra high net worth client in late 2009. In 2010, my portfolio was mostly focused on REITs and financials, but Chanos’ thesis on China intrigued me. My first six months went very well, before I had a period of underperformance during the Eurozone crisis. Much of it was driven by investments in small banks; a sector where I had underestimated the regulatory risks of Dodd-Frank; coupled with an overly aggressive FDIC.
In my first six months, I generated a return of 28.2% vs. the S&P return of 8.3%. Not a bad start to my career as a PM. In the next 12 months, I struggled much more, losing -2.0% versus an S&P performance of +14.9%. I was still ahead overall by about 100 to 200 bps, but it was a humbling period.
It was right after that I began another major period of outperformance in part driven by the China thesis. Over the course of 3 years, I implemented two separate put option strategies related to the Chinese Asset Bubble. The first was a big success. The second, I never got to see through, but with the market crash of the past few months, it’s clear that it would’ve been an even greater success.
The Commodity Short Strategy of 2011
I had remained intrigued by China in late 2010. I was new to the world of short-selling and had not yet grown very comfortable with it. My client introduced me to options trading in 2010 and I had slowly experimented with very small positions. I grew more comfortable over time.
Around April 2011 as commodity prices were surging, I put two and two together and decided that instead of directly shorting China, I would use a put option strategy. I was more comfortable with the idea of limited downside.
Moreover, instead of targeting China per se, I felt like the commodity producers were much stronger targets. I reasoned that even if China engineered the so-called “soft-landing” (a result I have always viewed as unlikely), that commodity producers would still see major reversions towards the mean, hitting their stock prices significantly.
I had great familiarity with the commodity space after buying in during the 2008 crash and thought that copper and silver prices were greatly inflated. Moreover, I thought the prices on rare earth minerals were out of the stratosphere and had nowhere to go but down.
Around April 2011, I decided to buy long-dated put options on several companies in that sphere. Copper producers Freeport McMoran (FCX) and Southern Copper (SCCO) were my two of my bigger focal points, but silver-related companies such as Pan American Silver (PAAS) and Silver Wheaton (SLW) were also included. I also bought put options on Stillwater Mining (SWC).
Yet, the most important prong of my strategy was the most difficult to implement. I bought deep out of the money put options on two rare earth mineral companies, Molycorp and Rare Element Resources (REE). These were my two highest confidence picks, as I felt that rare earth prices, which had surged anywhere from 500% – 3000% over the prior 3 years (depending on the particular mineral) were destined for a plunge within 18 months. This made rare earths perfect for a put option oriented strategy. Buying puts on those two companies proved to be a little trickier than expected and I had to slowly build the positions over a period of 4 to 6 weeks.
Since I was relatively new to the world of option trading, I decided to limit these positions to about 0.75% – 1.00% of the portfolio. I didn’t want to get carried away until I felt more comfortable with these sorts of strategies, but it ended up working out very well. In baseball terminology, I had hit solid doubles and triples on the copper, silver, and platinum portions of the portfolio (100% – 300% returns on the positions), but the rare earth puts were home runs, generating returns in the 500% – 1000% range in about six months time.
Interestingly, my portfolio still underperformed during those months as I had started buying into the homebuilders a few months earlier, and my homebuilder positions were getting hit hard. This was good news to me, however, because the builders were absolutely dirt cheap at that point, so I used the profits off the commodity puts to increase my stake in the US homebuilders, particularly Pulte Homes (PHM) and Toll Brothers (TOL).
The commodity put strategy coupled with my buys in the homebuilder, real estate, and the financial sectors would help fuel a major period of outperformance for me. From September 2011 through June 2013, I generated a 78.7% return compared to the S&P 500 gain of 31.8%.
The Delta Call Option Strategy
While I was “short” on China related themes the entire period from 2011 – 2014, it became less of a focal point in 2012 after commodity prices correctly significantly. The next big period in the China short theme doesn’t come till 2013.
Before I move forward into that, however, we should first take a bit of a detour to a completely unrelated Delta Airlines call option strategy in 2012. The Delta call option strategy was a failure for me, but should not have been. As such, I learned a valuable lesson from it and it influenced how I ended up implementing the second big stage of put option strategies related to the Chinese Asset Bubble.
You can see my basic thesis for Delta in an article titled, “Why Airline Profits Will Fatten Over the Next Decade.” In that article, I point out that there were several trends working in favor of the airlines in 2012. The most notable trends included