Short Term Opportunity in the Other Trade War

As the Trump Administration continues its talks with China’s Xi Jinping’s government over tariffs and a truce in their trade war, one company feels hung out to dry.

Harley-Davidson (HOG) is the poster child for a company that got caught up in these trade issues and how not to respond. Here’s the thing: it’s the European Union that’s putting the motorcycle company in its crosshairs.

China is the United State’s largest trade partner in terms of total trade per country. But as a whole the EU does the most business with the U.S. Some $717.9 billion worth of goods cross the Atlantic between buyers and sellers.



So, when the trade war kicked off last year, one of the first retaliatory moves by the EU was to single out one company it believed to be important in Trump Country: Harley.

The company, for its part, has tried to do everything in its power to not be bitten by this. It decided to move operations overseas, focus on new areas and new products like Asia and electric scooters. But this only caused backlash from its former core customer.

Many Harley-Davidson customers followed the President’s advice to boycott the motorcycle giant. It is now clear that those boycotts, along with the obvious decrease in European markets, have started to crush the company.

In just the fourth quarter, HOG missed its earnings in a stunning fashion, coming up nearly 40% short at 17 cents compared to analyst estimates of 28 cents.

Many pundits and financial writers are now saying that maybe tax refund season might help. But we’ve all already seen the news of decreased returns across the U.S.

Economic worries have swept across the world, with a slowing Chinese economy and the European Central Bank just today announcing lowered guidance and extended 0% rate targets.

For Harley, it might not get better for a long time. The Trump Administration is seemingly focused on just putting out fires the Democrats have begun lighting into the President’s personal finances, investigations and House committee hearings.

The only proactive thing we’re hearing from the Administration is its trade negotiations with China – which won’t really help Harley in any meaningful way even if successful.

You don’t have to be a political scientist or economist to see that this doesn’t bode well for the motorcycle company.

Stocks are now down for the fourth straight day. For companies like Harley, even if that trend reverses, its own stock might not follow.

This presents an opportunity for options traders, however. And there’s a strategy specifically designed to take advantage of this short-to-medium-term bearish outlook.

A Strategy For Short Term Bears

A bear call spread is a type of trade that’s designed to profit off any type of move in the underlying stock except for a rally.

If shares fall, a bear call spread trader profits. If shares don’t move at all, he still makes his maximum profit.

And best of all, his risk – in the event shares do rise during the period of time the contracts cover – is known upfront and is limited.

The way it works is by selling an at-the-money call option on a stock he thinks will see downward pressure in the short term. He then buys an out-of-the-money call with a higher strike price.

This creates a net credit for his account. The sold call will have a higher premium than the bought one. He gets that difference up front.

It’s also his total maximum profit.

The risk is found by taking the difference in strike prices and subtracting that upfront credit.

Here’s how that trade looks:

bearcall

Source: The Options Industry Council



Let’s look at a specific example…

A Specific Trade For HOG’s Weak Outlook

A trader looking to use this strategy to play the black cloud over Harley-Davidson could sell-to-open an April 18 $37.50 call for $1.50 per share and buy-to-open an April 18 $40 call for $0.51 per share.

Since each call contract represents 100 shares of HOG, that’s a net credit to the trader’s account of $99 ($1.50 – $0.51 = $0.99; $0.99 x 100 shares = $99).

That’s his maximum profit on this trade: $99. If shares don’t move at all or indeed fall, he keeps this whole amount. Harley doesn’t have to have any of those black clouds open up and start raining on it for this trade to work out. They just have to remain in place, keeping shares from rising. That’s the beauty of this type of strategy.

It isn’t completely risk-free, however. There’s a cost to have such a simple and straightforward profit upfront.

If shares do rise on, say, news of a trade deal with the EU or a boom in sales in Asia, this trade could lose money. Even that is unlikely, as the company isn’t set to report its next earnings until after these calls expire.

To find that risk, take the difference in strike prices ($40 – $37.50 = $2.50) and subtract the credit ($2.50 – $0.99 = $1.51). On 100 shares, that’s a maximum risk of $151.

Now, for the trader to lose all of that, shares would have to rise higher than $40 by April. As noted above, any rise is unlike… but that one is hard to fathom.

This all means that the trader’s $99 potential profit works out to a 66% return on the amount at risk. That’s not a bad profit considering shares of HOG don’t have to move an inch for it to happen.

It’s impossible to say when the White House will turn its attention to the nasty trade war with Europe. But even if it does so in the next five weeks, there’s almost no chance it’ll get anything done. And that means Harley’s black cloud should stick around for quite a while.

— The Option Specialist

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About the Author: The Option Specialist