A Tariff Trade
Tariffs are in the news. President Trump announced a plan to impose tariffs of 25% on imported steel and 10% on imported aluminum. In response, the European Union (EU), one of the US’s largest trading partners announced a plan to impose on US imports.
EU officials made it clear that there could be a targeted trade war if the US proceeds with its plans. Officials selected items that have particular political significance.
They threatened to impose tariffs on Kentucky bourbon, made in Senate Leader Mitch McConnell’s state. Speaker of the House Paul Ryan would be targeted on Harley Davidson motorcycles which are made in his district.
The officials did take a bipartisan approach. They threatened a tariff on blue jeans, targeting Levi’s which is an important company in the district of House Minority Leader Nancy Pelosi.
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In response to the European news, President Trump threatened a new tariff, this one on cars made in Europe and shipped to the US.
Trading the News
Tariffs are often associated with the Great Depression when the Smoot-Hawley tariffs were adopted. There is disagreement as to how significant the tariffs were but there is general agreement that the tariffs made the economic contraction at least somewhat worse.
Familiarity with that history led many traders to sell on the news that tariffs were being imposed. Fears of a trade war, combined with an already volatile stock market, resulted in several down days for the major stock market averages.
The direction of the next big move is likely to depend on the next big piece of news. If a trade war is advanced, the news should send stock prices lower. But, if the tensions associated with a trade war are lowered, the price of stocks should rise.
That makes trading a challenge since news is, by its nature, unpredictable. That has always been the case, but it is now more true than ever since news of the tariffs was announced directly by the White House without any leaks.
Leaks, or news stories that are selectively released to individual reporters before an official announcement, can reduce the market volatility associated with the news. Traders have time to consider the reliability of the source and the impact of the news when leaks occur.
Without leaks, we are left with large reactions on the news, and the large reactions can often be quickly reversed.
At times like this, it can be difficult for traders to determine which side of the argument they are most comfortable with. Fortunately, there are options strategies that allow traders to benefit from a market move without needing to take a directional bias.
We do know we should expect volatility, which can be traded with several options strategies. We also know an ideal stock for the trade could be United States Steel Corporation (NYSE: X).
The stock has been volatile on recent positive earnings. Another large move appears likely although the direction is not known.
A Long Strangle Benefits From a Large Move
The long strangle involves buying an out of the money call option and an out of the money put option, both with the same expiration date. This strategy can be used when a significant move in a stock is expected. This strategy can benefit a large move, without requiring the trader to form an opinion on the direction of the trade.
Like all options strategies, the long strangle is limited by time because all options have an expiration date. This strategy can be implemented when earnings are due since the date of that event is known. It provides potential gains based simply on the move.
The strategy hopes to capture a quick increase in implied volatility or a big move in the underlying stock price during the life of the options. The risks are known when the trade is opened and the potential gains can be large. This is shown in the diagram below.
Source: The Options Industry Council
The timing of the expected move can be difficult to determine. For many stocks, the strangle could be opened in the days before an earnings report is released. This would be a short term trade and options are well suited to short term trades.
A Specific Trade in X
X is trading near $45 a share. An out of the money call is one that has an exercise price above the current price of the stock. An out of the money put is one that has an exercise price below the current price of the stock.
For X, a strangle can be created by buying an $45 call and an $45 put, both expiring on March 16, the day after earnings are announced. The call is trading at about $2.20 and the put is trading at about $1.80.
To open the trade, a total of $400 will be required since each contract covers 100 shares. This example ignores commissions because they should be quite small, just a few dollars, at a deep discount broker. When trading options, it will be important to select a broker that offers very low commission rates.
Assuming X moves by 9% or more in the next month, this trade will be profitable. If X moves 20%, for example, the trade would deliver a gain of about 125%.
X has moved more than 54% from low to high in the past three weeks and another large move is likely based on option pricing models.
A 20% move would be equal to about $9. If it is up, the call would be worth about $9 and the put would be worthless. If it’s a down move, the put would be worth $9 and the call would be worthless. Either way, the gain is about 125% of the amount invested.
This return would be for a short term trade. If trades like this could be found once a month, the potential gains on the amount of capital required to open a trade would be rather large over the course of a year.
The risk of the trade is limited to the amount of money paid to purchase the two options. Even if X fails to make a large move, the size of the loss could be smaller than the amount invested assuming one of the options retains some value.
When news points towards potential volatility, the long strangle strategy offers a way to benefit from volatility rather than attempting to make directional calls on trades. This could be appealing to risk averse investors who understand the difficulty of forecasting short term price moves.