Market Report: How to Snatch 475% Gains From an Angry Dragon's Mouth

China today, and China tomorrow. One is the best ride available in the market today while the other is, quite possibly, the most massive cash trap of the 21st century. We’re talking gains that could make you rich beyond belief and pain on a level that will make you forget the tech and real estate crashes ever happened.

A quick peek at Hong Kong’s Hang Seng index reveals yet another banner day has joined the seemingly unending parade of strong gains. Currently trading at 29,540 it is up 702 points again today, a single day gain of some 2.44%.

Are we looking at a permanently rising market here, seemingly invulnerable to the same laws of physics that govern mere mortals such as ourselves? Nonsense! While China certainly has had ample growth, and will probably continue to roll through the rest of 2007, the seeds of a slowdown are in the ground, with little shoots already peeking out.

There are numerous specific areas where microeconomics reveals the macroeconomic downfall that is coming. A clear example can be seen in China’s once glorified and now frequently reviled export toy industry.

For the better part of the past decade, cost-conscious moms couldn’t get enough of discounted dollies and half-price hobbyhorses. Suddenly every “Mom’s Taxi” has its own miniature movie theater, and every middle-class suburban toddler’s playroom has a wooden train set that would have made a millionaire’s son jealous back in 1965.

Of course, there was a catch. Any appreciator of physics, economics or common sense can tell you that there ain’t no such thing as a free lunch, and the fee this time around is being paid by the kids who sucked the lead paint off Thomas the Tank Engine, and got sick unto death from poisonous sweeteners in discounted Chinese toothpaste.

Now those poor Chinese manufactures who were told to produce fastest and cheapest to feed our greed are getting a glimpse of the other face of America’s coin: self-righteous outrage.

We are shocked -- shocked, I say -- to discover that cheap toys must be made by slave labor, must use toxic ingredients, and must never, ever, be inspected en route because that would slow down a “just in time” supply chain.

But not too shocked to finesse just a little.

So now Chinese toy exporters are spitting venom over new inspection regimes that hold their products in warehouse an extra 10, 20 or even 30 days where once toys were on board containerships before the paint was dry. Now they cavil over paperwork requiring them to identify all the mysteriously cheap ingredients they use to bring costs in line with our demands.

“We’ll go out of business!” they desperately opine. Not to worry, fellas, at least not this year. Seems that while bureaucrats on both sides of the Pacific have made a brave show of their new stiffer attitudes toward dangerous doodads, behind the scenes they have slipped Chinese toys a “Get Out of Jail Free” card.

If your product is still in China, then you must comply with the new regimen. But if your product is already “on the water,” you are good to go. This is a critical caveat, as virtually all the product to be sold during the critical holiday season, when both American stores and Chinese manufacturers make some 70% of their income, are already riding the watery conveyor belt between eastern and western ports.

In other words, this year it behooves parents to watch what toys their rapacious children are chewing on. But next year, it behooves Chinese manufactures to learn to survive in Ralph Nader’s world of safety checks.

The upshot for investors? For the next quarter, Chinese profits will look better than anyone else. After that, intimations of mortality begin to creep in. Not necessarily an immediate crash, but rather the beginnings of some real friction yielding a rounding top in many major charts.

At that point, all it will take is one good scare, and suspicious investors will start to crowd exits. At this point I cannot tell you the exact date of that final crash (our esteemed publisher is less reticent and pegs it to the closing bell of the Beijing Olympics), but I can tell you how to squeeze the last juice out of this Asian pear.

In Taipan, I have been following the FTSE/Xinhua China 50 ETA with great interest. Specifically, I recommended buying FXI November 125 Calls (FAH KU) for $1,160 per contract. Today they are trading for $6,680, a gain of 475%.

With all this overhang building up in the Chinese market, this trade was certainly not without risk. To ameliorate some, I suggested purchasing an FXI November 106 put option (FJJ WB) for some $300. Thankfully, the sole job this put has had to perform was to absorb short-term volatility as the FXI climbed, thus preventing you from being stopped out during a few sudden drops. All told, your basket has earned you 360% grief-free gain over a few short months.

This will not hold true forever (after all, what does?). Now it is time to start thinking about the fact that this basket is getting long in the tooth. I personally do not choose to hold options in their front month (the 30 days prior to expiration), as they are entirely too prone to time decay.

Additionally, the increasing risk in the Chinese market calls for a small tweaking of the ratio between offensive calls and defensive puts. When I first set up this basket, I preferred a 4-to-1 cash ratio. Now I suggest selling that basket and locking in these extraordinary gains, and purchasing new basket additional time and either a 3-to-1 or possibly even 2-to-1 call-to-put cash ratio (for those of you who wish to play things more conservatively).

Those of you who are receiving my new Taipan Trader beta plays have already been positioned with a fresh FXI basket. Those of you who are not getting these new plays for free as part and parcel of your existing subscriptions should certainly write in to ask why not!

Adam