Profit From From This Tense US-China Relationship

Whether you are a news junkie or try to stay as far away from it all as possible, you know just how bad the tension between the Trump Administration and China has gotten. So far this week alone, we’ve had confirmation of a trade agreement, a tariff injunction, confirmation of no deal at all and a major international arrest of the CFO of an enormous Chinese technology company.

China, to say the least, is in the hotseat when it comes to economic and financial news. A quick recap…

Over the last year, President Trump and his counterpart Xi Jinping have been trading tariffs like a game of badminton. The two countries have placed import duties on everything from steel and aluminum to soybeans and automobiles. This last is what has sent both sides to the table of late.

General Motors announced recently that it is cutting 15% of its 54,000 North American salaried positions and will be closing plants in Canada and the U.S. This is directly related to the auto tariffs China is placing on the company’s products. There’re now rumors that Ford will follow suit with its own cuts due to this trade war.

This forced the leaders of the two largest economies in the world to schedule a sit down at the G20 conference in Argentina this past weekend. The topic, as one might guess, was how to end the auto tariffs.

Trump declared total victory, claiming the two reached an agreement to suspend tariffs in the new year. Then, it was 90 days from the meeting. Finally, it became clear that no such agreement could actually be confirmed at all. We still don’t really know what happened.

If you haven’t been paying attention, that’s one of the main reasons why markets fell by nearly 800 points on Tuesday… and are continuing today.

Now, if that wasn’t enough, Canadian authorities arrested Meng Wanzhou, the CFO and founder’s daughter of Huawei Technologies. Huawei is one of the largest technology hardware companies in the world. It counts among both its suppliers and customers hundreds of companies globally from Nokia to Qualcomm. The reason for the arrest is a charge that she violated U.S. sanctions on Iran. She is now facing extradition to the US.

This puts a giant new roadblock on the path to the whole US-China tariff negotiations table. It also signals just how serious this concern is between the two countries.

The problem for Wall Street, however, is not that the relationship could sour more… although that’s a possibility. The real issue for investors is the uncertainty of the whole situation.

Uncertainty, as you know, creates volatility. Volatility creates price swings. For option traders, those price swings create opportunities.

A Strategy to Potentially Profit From This Tense US-China Relationship

For most investors, traders and speculators, this trade war and its resultant souring of US-Chinese relations makes them uneasy to make any market move. The two economies are so closely tied together and we just don’t know what will happen.

A deal could very well be reached any day. If so, the tension eases, and investors can happily pile back into Chinese stocks. But just as likely, this latest offense (Wanzhou’s arrest) could be the straw that breaks the camel’s back. China could just as easily walk away from the table completely. It certainly won’t be in Xi Jinping’s best interest politically to strike a deal after what will surely be seen as a slap in China’s face.

So, the two behemoth economies will likely remain in a rocky relationship for some time. Either way, one thing we do know is that whatever happens, price swings in Chinese stocks will continue.

To play those kinds of massive movements, trading the iShares China Large-Cap ETF (FXI) makes a lot of sense. This fund is the largest Chinese equity fund traded in the US. The company has between $5 and $6 billion in assets depending on the price swings for its holdings that particular day. It is often referred to as a proxy to view the Chinese equity market as a whole.

So, when we’re talking about violent price swings for Chinese companies dealing with this trade war, FXI is a good choice to consider. Of course, buying it or selling it outright means you are taking a firm stance on how this whole thing will play out. Like we have said, that’s a tough call to make.

Instead, a trader looking to profit from the volatility alone could use a long straddle strategy.

A long straddle is a net debit trade that limits a trader’s downside to just his initial investment while giving him a virtually unlimited upside no matter which direction the underlying security moves. This is a pure volatility trade.

Here’s what this kind of trade’s profit chart looks like:

long straddle

Source: The Options Industry Council

As you can see, once the underlying company or fund’s share price moves a certain amount, any additional movement in that direction becomes pure profit. The way it works is by buying both a call and a put option with the same strike price and the same expiration date. This allows the long straddle trader to profit off a movement in either direction.

Let’s look at a specific trade for FXI.

A Specific Volatility Trade of FXI

With so much tension between the two countries, there’s no real need to buy long-dated calls to enter a long straddle on FXI. And with shares trading at exactly $41, that’s a perfect strike price to target.

So, to enter a long straddle on FXI right now, a trader could buy a December 21 $41 call for $0.93 per share and a December 21 $41 put for $1.17 per share for a net debit of $2.10 per share. Since each option represents 100 shares of FXI, that’s a total entry cost of $210.

That’s the total amount one could lose on this particular trade. If there’s absolutely no news on this front over the next few weeks, and shares of FXI do absolutely nothing, that $210 would be a loss.

However, if either an agreement is reached or we see any kind of fallout from the recent hostility, there’s a good chance FXI will move in one direction or the other. If that happens, this trade should be able to hit profitability. How profitably, as we noted, is up to just how much of movement we see.

To find the point of profit, one would need to take the total cost and apply it to the strike price. If FXI goes up past $43.10 per share ($41 + $2.10 = $43.10), the long straddle will start paying out. Likewise, if shares drop to $38.90 ($41 – $2.10 = $38.90), the put options will pass the point of profit for the trade.

This represents a 5.1% movement in shares price. Just today, those shares have already moved half of that amount, -2.5% as we write. This kind of movement would not be unprecedented. And if any major news breaks — either positive or negative — one could pretty much expect just such a move.

— The Option Specialist

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About the Author: The Option Specialist