When President Trump kicked off the trade wars with Europe and China, he first went after steel and aluminum imports. These are ongoing issues. But since the start of all of this, something else has happened.
Global demand has fallen off sharply. Both Europe and China have reported historically low manufacturing numbers. And the U.S. has been bracing for a potential recession for the last few months.
The Fed has even halted all interest rate hikes for the full year. And now, we’re seeing an inverted yield curve… scaring investors everywhere we look.
Yet, despite all of that, which would have dire consequences for companies like United States Steel Corp. (X), steel prices seem to have found a bottom:
As you can see, 2018 was quite a choppy year for the metal. After a devastating fall, prices seem to have stabilized since December.
That doesn’t mean, of course, they will remain where they are. All of the above economic problems could drastically change this chart yet again.
So, with all of that in mind, take a look at how US Steel is performing itself:
Clearly, it follows a similar pattern with a large drop off followed by a period of consolidation.
This all sets up a potential big move for the company. If the U.S. and China come to some kind of agreement, you’d think that would be a big win for all companies. But that’s not the case for X.
If tariffs ease, the already weakened demand for steel will be accompanied by an increase in supply. That’s not a good picture for the company. And if that wasn’t enough, it looks like US Steel is only going to add to its pain.
In February, the company announced it was restarting two facilities — one for pipes and the other for the raw steel itself. This is just going to add even more supply to the weighed down sector.
But even if the two countries can’t come to a trade agreement, that still won’t help with demand. And with industrial and economic woes everywhere, there’s only one place left to save companies like US Steel in the short term: government spending.
In theory, this is something the two political parties here in the U.S. should be able to agree to. The nation’s infrastructure has been too long neglected. And if the economy does tip downward, infrastructure spending could be a much-needed boost before the 2020 election.
But you’d be a fool to believe that the two sides will agree on any major project like that… at least any time soon. Right now, Washington is even more gridlocked than usual… with Congress split between itself and the White House torn in several fifferent directions all at once.
So, the near-term outlook for steel prices, and therefore US Steel itself, is bleak. Fortunately, there is a way to still play it.
A Strategy For Short Term Weakness
A bear put spread is a type of trade that involves buying one put option with a strike price near the current price of the underlying stock and selling a second put option with a lower strike price.
This second one helps offset the cost of the first. It still results in a net debit, but it is far cheaper – and therefore less risky – than simply buying a put option or shorting a stock directly. After all, the only risk in this type of trade is the cost it takes to enter it.
You can see how a bear put spread trade works here:
Source: The Options Industry Council
As you can see, the risk is limited to just the entry cost. But potential profits are capped as well. That’s the exchange for lowering the amount at risk. But that doesn’t make this a bad deal.
In fact, for U.S. Steel right now, the potential reward far outpaces the little at risk. Let’s look at a specific example.
A Specific Trade For X
Right now, a trader wishing to play the short-term weakness in US Steel’s share price could buy a May 17 $20 put for $1.57 per share and sell a May 17 $17 put for $0.49 per share for a net debit of $1.08 per share. Since each put controls 100 shares of X, that’s a total cost of $108 to enter this bear put spread.
That $108 is the total amount the trader would have at risk over the next seven weeks. But the potential reward is well worth that.
To find the maximum profit potential, take the difference in strike prices between the puts ($20 – $17 = $3) and subtract the entry cost ($3 – $1.08 = $1.92). Again, on 100 shares of X, that’s a potential return of $192.
In other words, this strategy lets a trader reap a potential return of $192 with only a $108 risk. If the trade works out, that would be a 178% return on the amount at risk.
Shares would have to drop below $17 for that to happen. But with so much weighing down the industry, that’s quite possible. This could be a quick, easy return even if Trump and Jinping can strike a deal.
— The Option Specialist