Trade war trade

July 2, 2018 10:28 AM

In the 2016  presidential election, Donald Trump’s two main issues were immigration and unfair trade practices. Immigration has continued to be a hot issue since President Trump was inaugurated in January of 2017. The Perdue-Cotton bill arguing on behalf of favoring skilled workers as immigrants led the news for a while.

The Deferred Action for Childhood Arrivals (DACA) fix that looked like it was going to sail through before it was derailed is yet another example. Lastly, the border wall has been a constant source of debate. It does appear to be all talk, however. Congress only appropriated only $1.6 billion for the construction of the wall. 

The issue of unfair trade practices seemed to be dead in the water. Trump’s economic team’s history was cool to the idea of tariffs. Every time the President brought up the subject they were able to diffuse the subject. Peter Navarro, a trade war champion, was able to circumvent the President’s economic team and get Trump’s ear. On March 8, 2018, Trump announced a 10% tariff on imported aluminum and a 25% tariff on imported steel. This was good for steel and aluminum producers but not so great for the manufacturers who used steel and aluminum. 

In 1817, economist David Ricardo developed the classical theory of comparative advantage. For example, if one country’s climate has an advantage in growing apples while the other country has an advantage in growing oranges, it makes sense that each country grows their specialty and import the other country’s specialty. This winds up being a win-win for both countries. That is except for the apple growers in an orange-suited country and vice versa. Those people also vote, so the ideal world of free trade is often sidetracked. 

Sometimes a trade war breaks out when tariffs are being imposed on a tit-for-tat basis. One sector of the U.S. economy that would be badly hurt by a trade war is agriculture. The trade in farm goods reduces the trade deficit. As a leading exporter, farmers have done quite well in recent years. A reduction in exports would drain revenue and cause a bear market in farmland.      

Trading a Trade War 

It could be that the trade issue will be resolved. There is a strong incentive for President Trump to settle things. There are plenty of electoral votes in the farm states. In the meantime, there should be plenty of volatility. John Deere & Co. (DE) is a major farm equipment manufacturer. The 52-week range for DE is $109.79 to $175.26. DE is currently trading at $135.33, which is in the low-to-middle part of its range. DE has a very reasonable price to earnings ratio of 30.76. 

One way to take advantage of impending volatility is to buy a straddle. This means you buy the at-the-money calls and puts. A straddle anticipates a move in the stock but doesn’t have an opinion as to whether the stock moves up or down. 

When you buy a straddle, you want plenty of movement, and when you short a straddle you want as little movement as possible. In late April, the DE 2018 May 135 calls had a delta of 0.57. This means that each call represents 57 shares. The DE 2018 May 135 puts had a delta of -0.43. This means that each put represents 43 shares of short stock. When the straddle is bought 20 times your equivalent share position is long 280 shares. Long options are a wasting asset. The time value that wastes away for each day is $13. That is a total loss of $520 per day. A few days of little movement can really hurt. Each day the rate of decay increases the closer it gets to expiration day. 

Traders can hedge this position with a short straddle. The weekly options that expire on May 4 decay at a much more rapid rate since expiration day is only four days away. The delta for the May 4, 135 calls is 0.54 and the corresponding puts have a delta of -0.46. 

Selling the straddle 10 times would represent 80 short shares of stock. The daily decay for each call and put is $25 a day. Since it is a short position, the decay collected amounts to $500 a day. The net decay is a loss of $25 daily. Since there are only four trading days left, the net decay will become more positive with each passing day. 

If DE expires at 135 the position will be profitable. If DE moves up or down three points it should be a breakeven. The DE weekly expired on May 4, at $137.29, making it marginally profitable. It would lose more money if it followed the trend for another three points. Beyond that it would become profitable again. Of course, the position could be even more profitable if prudent judgments are made while making adjustments. 

The calculation for this trade is the continued saber-rattling between the United States and China on trade. As the president makes belligerent comments and China responds with its own threat of tariffs —like stating it will halt soybean purchases — the market will exhibit volatility. Traders can reestablish their long straddle position like the example above, adjust it and take profits as the markets react to the ebbs and flows of the political posturing. 

This can be an effective strategy throughout the summer for markets — stocks, futures and exchange-traded funds — that are tied to agriculture, which will be particularly vulnerable to a trade war or simply trade war posturing.  

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.