This is NOT investment advice! Do your own due diligence.

Chinese equities suffered sharp selloffs due to policy-related concerns. KraneShares CSI China Internet ETF (“KWEB”), a popular Chinese ETF, declined by as much as 25% over the three-day period from last Friday to this Tuesday — a massive decline since KWEB has previously already declined by 40% from February to June! By Tuesday night, KWEB was down more than 55% from this year’s peak. See the chart above. What a financial “bloodshed”!

If one were watching the market close enough, he/she could discover an asymmetric opportunity during the Tuesday selloff. In a nutshell, between 11:30am and 1:30pm Tuesday (July 27, 2021), for KWEB, its exchange-listed long-dated call options were selling at a price so low that basically “guaranteed” investors great returns.

Here are my reasonings:

1. During that two-hour time window, KWEB was trading at approximately $46 per share. KWEB’s one-year-maturity call option with a strike price of $55 was selling for as low as $4.35 per contract.
2. Any option calculator can show that for such a long-dated option, it would still be worth approximately $4.4 per contract by the end of 2021 (i.e., investors buy it now and hold it for approximately five months) — as long as these two things happen:
   • KWEB recovers to $55 per share anytime during the next five months.
   • By that time, KWEB’s implied volatility stays above 30%.

Here is the key — I believe that both are extraordinarily easy targets to hit. KWEB was trading at $100 per share this February, $70 per share a few weeks ago, and $60 per share last week. Since the start of the pandemic (Q1 2020), KWEB’s historical volatility and implied volatility have both stayed firmly above 30%.

Put differently, it is extremely unlikely that from today until the end of 2021, KWEB will not be able to touch $55 a share even once. It is also extremely unlikely that KWEB’s implied volatility will drop below 30% and stay there. Putting the two together, I argue that it is extremely, extremely unlikely for both of these two negative downside situations to occur. So, the chance that the option price would never be higher than $4.4 per contract for the remaining days of this year is extremely, extremely low. Therefore, the potential downside was very little.

The potential upside was massive: if KWEB later recovers to $60 a share, investors can 1x or 3x his/her money (depending on time and volatility); if KWEB reaches back to $70 a share, investors can earn 3x to 5x (depending on time and volatility).

The opportunity was so unusual that you can almost call it “free” money.

Nevertheless, there were still risks. The risks included at least the following:

• More selloffs: Consecutive rapid drawdowns cause consecutive rapid shrinkage in option value, “forcing” casual investors to cut losses and exit.
• Declining implied volatility: The price of KWEB does not recover but the implied volatility keeps declining, causing investors to suffer a slow and painful process of constant mark-to-market losses.
• Lack of liquidity: Investors might find themselves with little market liquidity by the time they want to exit, and the ensuing unreasonable bid/ask-spread eats away investors’ hard-earned IRR.

All in all, for investors who are sensitive to market sentiment, Tuesday’s KWEB and its options market offered them two hours of almost “free” money.

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