Chinese Stock Market Correction Ahead? Here’s How to Profit

Chinese StocksChina is in the news, but not for good reasons. While the Chinese stock market continues to blaze along in 2015, outperforming our domestic markets, the associated risk is high.

While I like China in the long-term, I have not been zealously into Chinese stocks for a while, from neither an investment nor a trading standpoint. For me, there have been much better trading opportunities in the domestic stock market and the risk is lower here than trading Chinese stocks. In China, you just never know what you will get, whether it’s fraud, sudden changes in regulation, or even suspect numbers produced by the government.

Alibaba Group Suspicious: The Risk Associated with Chinese Stocks

Take the case of the Chinese Internet star Alibaba Group Holding Limited (BABA). At its highly anticipated initial public offering (IPO) back in September, the stock was hyped up as the best company to come out of China. But since then, it has been on a rocky road, with the stock declining to a low of $80.03 on Tuesday.

The problem with Alibaba may or may not be true, but the issue of reliability continues to be a problem when analyzing Chinese companies. We have seen this in the past with U.S.-listed Chinese companies, especially those via the rather sketchy world of pink sheets and over-the-counter (OTC) stocks.

In the case of Alibaba, there are allegations of “brushing” occurring at web sites operated by the company. This implies what is known as fake orders initiated by the web sites to give the appearance of rising orders, thereby driving up the company’s valuation. Of course, nothing has yet been proven, but I recall the old saying, “where there is smoke, there is fire.”

The risk in China is not only with reliability, but there are clearly concerns regarding the condition of the Chinese economy, specifically the financial and real estate sectors.

The People’s Bank of China just cut its interest rates for the second time over the past few months in an attempt to inject liquidity into the economy that is obviously hurting. The Chinese government cut its projected gross domestic product (GDP) growth target to seven percent for this year. In reality, the economy may already be growing at a rate less than seven percent, it just depends on whether you trust the numbers.

We are seeing some froth in the Chinese capital markets. Another 24 IPOs were approved for the Shanghai and Shenzhen markets. We are also seeing more stock brokerage firms surfacing in the country, which is a red flag given the gains this year.

How to Play This Potential Investment Opportunity

Two ways to play the froth and a potential market correction in Chinese stocks is to consider buying put options on several available U.S.-listed, China-focused exchange-traded funds (ETFs), or to short the Shanghai Stock Exchange Composite (SSE) if you have access to the Shanghai-Hong Kong Stock Connect through your broker.