This Could Be How a Trade War Starts
Wars are often the result of a series of events. Sometimes, there is no intent to start a war, but one event leads to another and eventually, conflict results. That is true of wars that involve violence and trade wars.
We may be seeing the early stages of a trade war after China announced steps to retaliate against steel and aluminum tariffs that the US imposed. China’s next steps will include 25% tariffs on pork, 75% tariffs on fruit and dozens of other targeted tariffs.
“In order to protect its interests and compensate for the damage caused by the measures taken by the U.S., China has ceased its obligations to reduce customs duties on 128 categories of goods of on seven categories imported from the United States,” the Chinese Ministry of Finance said in a statement. They said the need was to compensate for losses due to the metal tariffs.
As always, it’s important to dig into the news and discover the significance of events. In this case, the pork tariffs are increases on what were already significant tariffs. One expert noted,
“The pork tariff means an increase of around five percentage points, depending on the type of pork meat exported. For example, according to the U.S. Meat Exporters Federation, China charges a 20% tariff on chilled pork and a 12% tariff on frozen pork. China also charges VAT taxes in the teens, so it may be that this increase is not all that much from what pork exporters are already living with.
Despite the already existing tariffs, last year, the US pork industry exported $1.1 billion of pork products to China, making it the third biggest market in terms of dollar value. Japan is No. 1 in terms of value. In terms of weight, the U.S. exported 309,284 metric tons of pork meat to China out of 2.45 million tons total.
For variety meat pork means, China is the No. 1 market with a 2017 value for Midwestern farmers and the big pork exporters of around $425.2 million. China accounted for more than one-third of U.S. pork variety meat exports last year.”
The US is the world’s largest pork meat exporter.
Tyson Takes a Hit
Tyson Foods (NYSE: TSN), a company associated with chicken, sold off on the news. Although Tyson is the largest chicken producer in the country, it is also among the largest beef and pork producers in the country.
The news adds to the company’s woes and weighs on the stock. As the chart below shows, TSN was already in a down trend.
The selling, however, could be overdone. TSN is now trading at less than ten times earnings and buyers are likely to offer support near the current price.
A Trade for Short Term Bulls
As with the ownership of any stock, buying TSN could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
A Specific Trade for TSN
For TSN, the April 20 options allow a trader to gain exposure to the stock.
An April 20 $70 call option can be bought for about $1.50 and the April 20 $72 call could be sold for about $0.75. This trade would cost $0.75 to open, or $75 since each contract covers 100 shares of stock.
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 $75.
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 TSN the maximum gain is $1.25 ($72 – $70 = $2.00; $2.00 – $0.75 = $1.25). This represents $125 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $75 to open this trade.
That is a potential gain of more than 65 based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.