As the S&P 500 clings to its all-time high and investors wonder if its 21 times earnings multiple is a little pricey, one market makes it look like a bargain-basement deal.

This stock market is trading for a staggering 44 times trailing earnings and has more than doubled in the past year. What’s even more perplexing is that stocks keep making fresh highs even as fundamentals continue to deteriorate.

The government has taken notice though, and may soon remove the punch bowl from the party. It may not be long before a correction turns into a full-blown market crisis.

How Quickly Sentiment Can Turn

Anyone invested in the Chinese market over the past decade knows how important sentiment is to prices. After a meteoric rise and subsequent crash during the global financial crisis, things seemed to improve quickly as the Shanghai Composite recovered off its late 2008 lows. 

Hopes that stock prices would surge again as the world’s second largest economy became a global powerhouse were dashed as the Shanghai Composite lost close to 40% in the five years following its 2009 high. 

But then, as the government sought to cool overheating in the property market, investors found a new way to gamble and piled into stocks, sending the index soaring.

This has all happened as economic growth was cooling. Q1 GDP growth of just 7% year over year marked the slowest quarterly growth rate since 2009. And there are warning signs of more weakness ahead.

Exports account for more than a third of the economy in China. The government has sought to keep the value of the yuan trading closely with the U.S. dollar to control monetary flows, which means the country’s currency has risen along with the greenback.

The yuan has appreciated 8% against the euro since the beginning of the year and 25% over the past 12 months. The appreciation has already hit exports, which plunged 15% in March from a year earlier and were factored into recent stimulus measures by the country’s central bank.

So what’s behind the meteoric climb in stock prices? Try 1.6 trillion yuan ($274 billion) in margin borrowing. Investors have borrowed hundreds of billions in debt to buy stock, sending margin loans up 321% over the past year.

Not including government-owned shares, the ratio of margin debt-to-market capitalization on the Shanghai and Shenzhen stock exchanges has reached 8.2%, higher than any other example in history.

The government may not let the party go on much longer. Chinese authorities have a reputation for trying to closely control asset prices. The clampdown on the red-hot property market over the past several years may be part of the reason investors are rushing to stocks.

And securities regulators are already watching stock prices closely. The Shanghai index plummeted 8% on Jan. 19 when the China Securities Regulatory Commission (CSRC) banned the three largest brokerage firms from opening new margin accounts for three months. The sell-off was short lived, and the index has since surged by nearly a third.

#-ad_banner-#As you can probably tell, I’ve been closely watching the Chinese stock market over the past several months. I believe emerging markets should outperform developed peers over the long term as technology helps them catch up economically, so nearly a fifth of my portfolio is in stocks of emerging market companies. 

But short-term prices are still very closely correlated to what happens in China. A sell-off in China’s stock market might mean a commensurate drop in emerging markets, and I want to protect myself. 

The trader in me has been watching the Chinese market as a way to profit from an obvious bubble in asset prices. Even on GDP growth around 7%, a price-to-earnings (P/E) ratio of 44 across an entire market is unsustainable, and it is only a matter of time before sentiment turns. 

Luckily, there’s an option strategy that will allow me to protect my portfolio and profit from a collapse in Chinese stocks. 

Protection and Profits With Puts

Options can be a great tool for protection. Buying put options on a stock or an index is often referred to as “buying portfolio insurance.”

Because a put option gives you the right to sell shares of the underlying at a specific price, called the strike price, it functions as a hedge against a large drop. The strategy will cost money and moderate your returns if prices keep moving higher, but it is a godsend if the worst-case scenario plays out.

Buying put options on an index ETF to protect against losses in specific stocks carries an added benefit. Since the ETF is likely much less volatile than a single stock, the premium on the put options will be lower.

When it comes to funds with exposure to Chinese stocks, none are as liquid or as large as the iShares China Large-Cap (NYSE: FXI). The fund holds shares of the 50 largest Chinese companies traded on the Hong Kong Stock Exchange. While large companies have not soared to the heights seen across the market in general, the fund has still jumped 49% over the past year. Financials make up 47% of the fund, which means that a collapse in margin trading and financial accounts could hit shares significantly.

With shares of FXI trading for $51.80 at the time of this writing, we can buy a FXI Jul 51.50 Put for $2.70 per share ($270 per contract). Buying the put gives us the right to sell shares of the ETF for $51.50 on July 17. 

This trade breaks even if shares fall to $48.80 (strike price of $51.50 minus premium of $2.70), 6% below current prices.

For portfolio protection, I usually devote 3% of my portfolio to buying puts. Since I am only looking to protect a fifth of my portfolio — the portion I have in emerging market securities — I want to commit roughly 3% of that amount to buying puts on FXI. For example, if you have a $100,000 portfolio, with one-fifth ($20,000) in emerging markets, then you would buy $600 worth of put options.

If the ETF closes above $51.50 on July 17, the put will expire worthless, but I’ll keep the gains made on the rest of my portfolio. If FXI closes below $51.50, I’ll collect the difference, which will help offset any losses on my portfolio.

My goal here is for FXI to fall about 8% — like it did in January — to $47.33 by expiration. If the ETF hits that price, my put option will be worth at least $4.17 ($51.50 strike price – $47.33 stock price).

The Chinese market has shrugged off short-term panics over the past year, so I want to take advantage of any quick sell-offs as they happen. To make sure I don’t miss my opportunity, I want to place a good ’til cancelled (GTC) limit order to sell my put option at $4.17. Since I bought the option at $2.70, if it hits my price target, I’ll generate a 54% gain in less than 76 days.

Stock markets and individual stocks tend to fall much faster than they rise, making put options a great way to earn big profits in a short amount of time (with limited risk).

Case in point, my colleague, Jared Levy, just booked a 40% gain in 29 days thanks to Yelp’s (NYSE: YELP) post-earnings sell-off this week. And last month, he locked in a 34% return in 56 days on an 11% drop in Keurig Green Mountain (NASDAQ: GMCR). 

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This article was originally published on ProfitableTrading.com: Think the S&P is Expensive? Look Out, This Market Costs Double