Are We Heading back to the 1920s?
Many investors are thinking of the 1920s. That was a time when the stock market rallied sharply before crashing at the end of the decade. Those memories are never far from the minds of some investors. The crash of 1929 changed the lives of investors and ushered in the Great Depression.
Economists debate the causes of the Great Depression. Some do attribute part of the blame to the stock market crash. Investors had been caught up in a bubble and many had traded on margin to increase the potential gains. At the time, stocks could be bought with just 10% down.
Well, investors are once again enamored with margin debt as the chart below shows.
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Source: Advisor Perspectives
Margin debt is at all time highs along with stock prices. In the past, this combination has been seen before bear markets.
Another Historical Parallel
Economists also blame the Great Depression on tariffs. The Tariff Act of 1930, more commonly called the Hawley-Smoot Tariff, raised U.S. tariffs on over 20,000 imported goods. The tariffs were the second-highest in the U.S. in 100 years.
The Act and following retaliatory tariffs by America’s trading partners helped reduce American exports and imports by more than half during the Depression. Although economists disagree by how much, the consensus view is that the passage of the Hawley-Smoot Tariff exacerbated the Great Depression.
While the tariffs in the act were large, the debate on the subject had been running for years and it began in small ways with small acts. That is the parallel with today.
Boeing (NYSE: BA) won a victory in a tariff dispute with Canada’s Bombardier aircraft company. The Commerce Department recommended that a 220% tariff be imposed on each Bombardier C Series jet delivered to the U.S. after Boeing accused the Canadian aerospace giant of receiving $3 billion in government subsidies, giving it an unfair competitive advantage.
A second ruling is expected on Oct. 5 but the U.K. is already upset about the recommendation as 4,200 Bombardier jobs in Northern Ireland could be at risk over the decision. The decision reached the highest levels of government and drew a sharp response.
“What I would say in relation to Boeing is that of course we have a long-term partnership with Boeing in various aspects of government and this is not the sort of behavior we expect from a long-term partner and it undermines that partnership,” Prime Minster Theresa May.
May reportedly had personally asked for President Trump’s help in ending the dispute.
The U.K. has a Boeing P-8 maritime surveillance plane on order, along with a fleet of new Apache attack helicopters. Officials have said that Britain would not cancel those orders but would take a look at two other future contracts Boeing was likely to bid on.
Canadian officials also responded to the news and threatened to cancel a planned purchase of 18 Boeing F/A-18 Super Hornet jets over the ruling. Bombardier also pointed out that the C Series supported 23,000 jobs in the U.S. and the jet’s engine is made by United Technologies’ Pratt & Whitney unit.
Trading the News
Boeing has been among the market’s top performers in the past year. The stock rallied more than 90% since the November election on expectations that a defense buildup would benefit the company.
In the chart above, the dividend yield is shown in the center of the chart and the price to earnings (P/E) ratio is shown at the bottom. Both indicators are shown with Bollinger Bands, a technical indicator that can be applied to any data series.
Bollinger Bands uses standard deviations to define the “normal” values of an indicator. They are drawn two standard deviations above and below the average value, in this case the average dividend yield and P/E ratio. In this way, they contain most of the values and show when extremes are being reached.
Both fundamental metrics have been near overbought extremes almost since the time that the rally began. That indicates the rally could fail at any time. News, perhaps the news related to tariffs, could trigger a sell off in the stock.
A Trading Strategy to Benefit From Potential Weakness
Boeing now faces pressure since it could lose contracts because of the tariffs intended to help the company. This could lead to a sell off in the stock.
However, even if the stock doesn’t decline much, in the short term, Boeing seems unlikely to rally sharply. Traders will most likely want to see proof the company can overcome this news and they will most likely be watching for retaliation from other countries.
This means traders should consider using an options strategy known as a bear put spread to benefit from the expected price move.
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.
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
The bearish outlook for BA, 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 expires. 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 October 6 $255 put can be bought for about $2.40 and the October 6 $252.50 put can be sold for about $1.50. This trade will cost about $0.90 to enter, or $90 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The maximum loss is experienced if BA is above $255 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 premium paid, or $1.60 in this trade ($255 – $252.50 = $2.50; $2.50 – $0.90 = $1.60). This represents $160 per contract. Most brokers will require minimum trading capital equal to the risk on the trade, or $90 to open this trade.
That is a potential gain of more than 100% on the amount risked in the trade. This trade delivers the maximum gain if BA closes below $252.50 on October 6, when the options expire. The gain is so high because there is a significant risk BA will be above $255 when the puts expire, as it is now.
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 $90 for this trade in BA.