Contrarian trade – Time to invest in Europe?

The US Fed may be getting closer to raising interest rates.  Fed Fund futures are now implying a 54% chance a rate increase.  So, the US Fed is focused on raising interest rates meanwhile the ECB is at the opposite end of the spectrum.  ECB President Mario Draghi is still in the “whatever it takes” mode to stimulate growth.  Considering that Draghi and Co are acting as a backstop to the EU economies, European equities may begin to outperform US equities.  Take a look at the relationship between VGK (Vanguard FTSE Europe ETF) vs SPY (SPDR S&P 500 ETF Trust) over the last year in the chart below.  VGK has massively underperformed SPY.  One of the contributing factors that supports the underperformance is there has been large redemptions in European related ETFs.  Since the beginning of the year European ETFs have lost $3.4B in assets. 

VGK vs SPY – 1 year chart

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Source: Bloomberg

Similar to watching the above chart for change in trend, fund redemptions may also begin to slow considering how much has already been taken out of these ETFs.  Interestingly, on Tuesday, bullish option activity picked up in the VGK ETF with 20,000 July 50 strike call options trading.  This new position opens the largest open interest block in the product (according to Trade Alert LLC).  Here is a trade idea to capitalize on a possible shift in trend between the VGK and SPY ETFs:

Tribeca Trade Group Trade Idea

Using Options: Apply a “Limited Risk Reversal” style Pair Trade:

-          Purchase the VGK July 50 calls & sell the July 45 / 48 put spread to help finance the cost of the calls

-          Purchase the SPY July 205 puts & sell the July 210 / 213 call spread to help finance the cost of the puts

Disclosure: This is a complicated and higher risk option strategy.  

Or using stock

-          Purchase the VGK ETF

-          Sell short the SPY ETF

Note the above type structure is thoroughly explained in the Tribeca Trade Group trading room.  Follow @cfromhertz on twitter for more info.


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