How to Trade When Markets Do the Unexpected
Traders develop expectations for the market. In broad terms, they expect bad news to lead to selling and good news to result in buying. This often happens, but occasionally markets do the unexpected.
As a recent example, we can look at North Korea’s most recent missile launch. After the markets in the US closed, North Korea fired a missile over Japan in a move Prime Minister Shinzo Abe called an “unprecedented serious and significant threat “to his country and US President Donald Trump said it was an act of “contempt.”
As a thought experiment, we can consider how we would expect the market to react to this news. This was the latest test of North Korea’s missiles and the first to directly fly over Japan. The path of the missile took it directly over populated areas.
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In response to something like this, we would expect to see traders selling Japanese stocks and currency. But, the yen rose on the news even though stocks did decline.
Reasons for Strength in the Yen
The yen has been moving higher as the North Korean provocations increased in recent weeks. The US dollar was trading at about 108.32 yen after the launch, down from prices near 111 yen that were seen earlier in August.
In the chart above, a downward move in the exchange rate indicates weakness in the dollar and strength in the yen. An upward move would indicate a weak yen and a strong dollar.
The gain in the yen stood in contrast to the movement of the South Korean currency. The South Korean won sank on the news of the launch. That movement was in line with conventional expectations that a currency will decline when a country’s national interests are threatened.
The move in the yen seems to be explained by the currency’s role in the market place as a safe haven. According to CNBC, Takuji Okubo, chief economist at Japan Macro Advisors, said that’s because Japan is a net overseas investor, both on the retail and institutional levels. This leads to a strong currency.
“For those Japanese investors who are invested overseas, having their assets in non-yen is a risk because they are exposed to foreign-exchange volatility,” he said earlier this month. “So when these geopolitical risks, or any risks, get heightened, they want to reduce risk and that means unwinding overseas investments.”
The reason for this is found in the size of the investments Japanese investors hold outside of their country. At the end of last year, they held around 159 trillion yen ($1.4 trillion) in direct investments and three times that much in portfolio investments, according to data from Japan’s Ministry of Finance.
Despite the economic justification, analysts note that selling is a logical response to military threats. “People with trigger fingers do a knee-jerk response. Never underestimate that factor,” Michael Every, head of financial markets research at Rabobank, said earlier this month.
Investors Did Sell Stocks
On the news of the launch, investors did sell stocks. In the US, futures markets were trading at the time and futures contracts of major market averages did decline. The Japanese stock market, the Nikkei 225 index, also sold off, as shown below.
Stocks do tend to move on news as expected more often than currencies do. This presents a potential opportunity for traders. If the situation with North Korea continues to dominate headlines for some time, the stock market indexes in Japan are likely to fall.
However, investors in the US will generally need to make trades based in dollars. This means they face a currency risk in their investments. Given this risk, it is possible the Nikkei could decline while US based exchange traded funds (ETFs) tracking the index rise. That would be the currency risk.
Hedge funds and large institutional investors are able to overcome this problem by hedging the currency risk. Hedging transactions can reduce or even eliminate the impact of currency movements on a portfolio. Individual investors could, in theory, hedge their exposure as well.
In practice, hedging transactions are expensive and difficult to maintain. A true hedge needs to be rebalanced over time to maintain the hedge. Otherwise, the amount of money placed in the hedge can become disproportionate to the original investment and act as a speculative investment.
A Trading Strategy
This is not the first time North Korea has launched a missile that crossed over Japan. This happened twice before. The first time was in 1998. The chart below shows that stocks in Japan were already weak at the time of the launch but moved lower after a brief rally on the news.
The second occurrence was in April 2009. At that time, global markets were at the beginning of a strong rally that began in March 2009. In hindsight, we know that the devastating global bear market that began in 2008 had ended in March.
North Korea’s missile launch interrupted that rally. The brief sell off came despite assurance from North Korea that the missile was being used to launch a satellite. This had also been the reason given for the previous launch almost eleven years earlier. The chart below shows the market’s reaction in 2009.
This Time Is Different
The most recent missile launch was not associated with the launch of a satellite. This time, the government of North Korea is in the midst of an extensive weapons testing campaign. The meaning of the launch is not a matter of speculation. This time, the meaning of the launch is a matter of concern.
Traders are likely to react as they always do at times of concern. They are likely to sell stocks. That means traders can benefit from owning put options or using other strategies that benefit from a decline in prices. Traders in Japan can use funds or stocks that track the Nikkei index.
But, traders in the US cannot count on a fund that tracks the Nikkei because of possible moves in the currency that could offset gains in the stock market index. There is an ETF that hedges currency risks, the WisdomTree Japan Hedged Equity Fund (NYSE: DXJ).
This fund completely hedges the risk of losing money because the yen moves against an investor and reduces or eliminates gains from correctly forecasting the trend in the stock market. Since the fund’s inception in 2012, the MSCI Japan Index has gained 59% while DXJ has gained 104%. The difference between the two is explained by currency fluctuations.
There are options available on DXJ. A trader looking to benefit from a potential decline in Japanese stocks could buy a put option with an exercise price of $51 that expires on November 17 for about $1.25. This option allows time for a significant move in Japanese stocks.
This put option is profitable if DXJ declines by about 3% before expiration. If DXJ declines by about 5%, the option will deliver a gain of at least 150%.
As always, the risks are limited when buying an option. An investor can never lose more than they paid to purchase an option.
There are more complex strategies available to trade the situation in Asia. But, this is a simple investment thesis – Japanese stocks are likely to sell off as North Korea continues testing its missiles and other weapons systems.
A simple strategy fits that thesis. The risks are relatively small in dollar terms and the potential gains are relatively large. Even if North Korea changes course, a sell off in global stock markets is likely and this trade would deliver a gain if that happens.