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An Overlooked Casualty of the Upcoming Trade War

An Overlooked Casualty of the Upcoming Trade War

Source: Anthropologie.com

News of the trade war is increasingly common. But, few investors have any experience with this type of event. In recent years, trade disputes have been relatively narrow in their focus with tariffs placed on select goods like iron or tires. These were small and targeted actions.

This time is different. Tariffs are being considered on large amounts of goods. The US government is considering imposing tariffs on $250 billion worth of goods imported from China. This upsets the current balance of action/reaction playing out in the global arena.

So far, the US has announced tariffs and countries have responded by imposing tariffs on a similar amount of US exports. But, China doesn’t import $250 billion worth of US products which means retaliation will require escalation.

For investors, this means that it’s time to look beyond the headlines. They must consider the possibility that escalation continues. It is time to consider which companies will be adversely affected by the trade war.

Retailers Could Suffer

Much of the focus, so far, has been on manufacturers. They will certainly be affected as prices of parts rise and sales in other countries potentially decline. But, other companies will also be affected.

Barron’s cited research from MKM Partners analysts that reviewed companies reliant on Chinese cotton and sourcing among apparel retailers.

The analysts noted that “Urban Outfitters’ (Nasdaq: URBN) reliance on goods made in China—and cotton grown there—could make it vulnerable if that country fights against U.S. tariffs by increasing import or materials costs on apparel.”

Express, Tapestry and Chico’s FAS were also listed as vulnerable, MKM wrote.

“While it doesn’t appear that finished apparel goods imported from China are under consideration for a tariff today, we expect the situation to remain fluid,” the analysts wrote. “A tariff on China manufacturing and/or a retaliatory increase to the cost of cotton would have negative margin implications for an industry already facing structural margin pressure.”

relative exposure to China

Source: Barron’s

“For retailers already fighting for survival,” MKM wrote, “a blow from higher cotton or sourcing costs could be the last straw.”

The price action confirms MKM’s concerns. The price of URBN was in a steady up trend for the first part of the year. But, upward progress stalled at the end of May.

URBN daily chart

The stock has now encountered resistance and been unable to reach a new high for several weeks. Selling pressure pushed the price below support after MKM’s report focused traders’ attention on the problems a trade war could cause for the company.

A Trading Strategy to Benefit From Potential Weakness

The prospects of further short term gains in URBN seem to be remote.  But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.

This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.

bear put spread

Source: The Options Industry Council

A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.

The Trade Specifics for URBN

The bearish outlook for URBN, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.

A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive.  The risk of loss when buying an option is equal to 100% of the amount paid for the option.

To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.

Specifically, the August 3 $43.50 put can be bought for about $1.10 and the August 3 $43 put can be sold for about $0.85. This trade will cost about $0.25 to enter, or $25 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spent to open the trade, or $25. This loss would be experienced if URBN is above $43.50 when the options expire. In that case, both options would expire worthless.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in URBN, the maximum gain is $0.25 ($43.50 – $43 = $0.50; $0.50 – $0.25 = $0.25). This represents $25 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $25 to open this trade.

That is a potential gain of more than 100% of the amount risked in the trade. This trade delivers the maximum gain if URBN closes below $43 on August 3 when the options expire.

Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $25 for this trade in URBN.

You can find more trades like this in the TradingTips.com service, Options Cash Cow. To learn more, click here.