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Trade War Claims Another Casualty in RIO

Trade War Claims Another Casualty in RIO

The long trade war seems to be continuing as The Wall Street Journal reported,

There has been no sign of a speedy resolution to U.S.-China trade tensions in recent meetings with American officials, Australia’s top finance minister said, despite President Trump’s more-conciliatory tone at last weekend’s Group of 20 summit.

Mr. Trump and China’s President Xi Jinping managed to get trade talks back on track last weekend, bolstering hopes of a break in trade hostilities between the world’s two biggest economies.

Australia’s Treasurer Josh Frydenberg, however, said on Friday he had seen no sign during meetings with counterparts or recent separate talks with U.S. officials that a resolution was on the horizon. “These issues aren’t going away anytime soon,” Mr. Frydenberg said in an interview with The Wall Street Journal.

This news does seem to be impacting Australian companies like Rio Tinto (NYSE: RIO).

RIO daily chart

The global nature of trade means the bilateral spat is dealing a blow to economic growth world-wide. In April, the International Monetary Fund reduced its global growth forecast for 2019 to 3.3%—growth was 3.6% last year—and said trade tensions could weigh on it further.

China’s demand has been the biggest driver of global expansion. The trade tensions risk exacerbating the Chinese economy’s slowdown, with the collateral damage likely to include Australian mining giants who would be hard-hit by any slip in China’s demand for Australian resources such as copper and iron ore.

Mr. Frydenberg met recently with U.S. Treasury Secretary Steven Mnuchin to gauge political resolve in Washington on a range of issues including trade and urge a de-escalation in global tensions. Australia is a supporter of trade liberalization. Last year, it joined 12 other members of the World Trade Organization in supporting proposed changes to the world trade umpire, which Mr. Trump has called “the worst organization ever created.”

Australia’s Prime Minister Scott Morrison used a recent trade-focused speech to indirectly criticize Mr. Trump’s negotiating style as a “a narrow, transactional approach” where longstanding alliance relationships were being wound back to “nothing more than the sum of our deals.”

While Canberra understands U.S. frustrations with the multilateral trading system, Mr. Frydenberg said the answer is in reforming rather than dismantling the dispute process or withdrawing altogether from the WTO. An appellate body at the WTO that handles trade disputes could become dysfunctional by the end of the year because the U.S. has blocked the appointment of new judges.

“While the World Trade Organization is not the flavor of the month, it can be re-equipped to deal with some of the issues,” said Mr. Frydenberg.

Australia’s resource-reliant economy is one of the world’s most China-dependent. Mr. Morrison’s conservative government has been anxiously watching for progress in trade talks amid concerns that any fallout could worsen already anemic growth and prematurely end a record 28-year growth streak.

RIO does remain near its 52-week high but weakness appears possible in the stock.

RIO weekly chart

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

A Bear Call Spread in RIO

For RIO, we could sell an August 16 $60 call for about $2 and buy an August 16 $62.50 call for about $0.90. This trade generates a credit of $1.10, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $110. The credit received when the trade is opened, $110 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $140. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($110).

This trade offers a potential return of about 78% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if RIO is below $60 when the options expire, a likely event given the stock’s trend.

Call 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 $140 for this trade in RIO.