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Trades

How to Play Trump’s Mexico Bombshell

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Last night, President Trump announced new sweeping tariffs on Mexican products that will start at 5% and gradually increase to 25% unless the country stems illegal border crossings into the United States. And, of course, the market exploded.

As I write, the Dow is down 283 points – on top of the more than 600-point drop from Tuesday’s morning highs in this shortened trading week. No company is going to be hit as hard as General Motors (GM).

Analysts and finance writers are already calling this an automotive tariff, despite it including all trade goods. Mexico’s auto parts industry has boomed over the last 25 years. And it is now a major factor in domestic U.S. auto sales.

General Motors has been the largest benefactor of the NAFTA agreement, which set this situation up from the beginning. About 27% of all domestically-sold Chevy and GMC models the company sells are Mexican made. And that’s just full cars. The parts for its other models rely heavily on Mexican production.

GM isn’t alone, though. Ford and Chrysler are both being put in a tough position with this new front of the trade war. However, this new policy could have some benefits to automakers.

You see, this new trade war with Mexico comes at a moment when the fate of NAFTA’s replacement agreement, the USMCA, is being finalized. House Speaker Pelosi has so far refused to move forward with any plans to vote on the ratification of this NAFTA 2.0, to the White House’s chagrin.

Just this week, the administration sent a draft statement to Congress to force at least some action. It doesn’t force the House to vote on anything, however.

With this new set of sweeping tariffs on one-third of the agreed countries, USMCA will face many more problems than just Pelosi’s obstinance.

So, let’s look at this deal. Specifically, the major differences between NAFTA and USMCA is what goes on in the auto industry.

Under NAFTA, non-North American countries have been sneaking parts through Mexico to the U.S. skirting their own long-standing tariffs on certain parts. USMCA would make it much more difficult to do that. That alone would hike the cost of domestic vehicles.

The USMCA also mandates that parts made for North American vehicles must be made in factories that pay employees at least $16 per hour. For many companies in Mexico, this would be quite a pay hike… and cost of doing business.

Finally, 70% of the steel and aluminum that goes into automobiles in North America would have to come from North America. Meaning even if the U.S.-EU and U.S.-China trade wars end and tariffs go down for steel and aluminum, the USMCA would still force higher input costs on those metals.

In short, the USMCA isn’t really popular with automakers. So, despite these tariffs on Mexican goods, including auto parts, there might be a tiny bright spot for them. These tariffs will almost certainly hold up ratification of the trade deal going forward.

So, how in the world could anyone invest in this crazy situation? Tariffs will certainly either eat into the margins at companies like GM or be passed through to customers in higher car prices, which would hurt sales. Yet, if they disrupt the USMCA even further, that might be a positive for GM and its domestic competition.

Fortunately, there’s a strategy you can use to play this situation without even needing to decide how much this new tariff will hurt or help the industry.

A Strategy for the Mexican Tariffs

A long straddle is a type of options trade that plays price movement, not direction. The way it works is by buying both a call option and a put option on a stock that you believe is likely to see increased volatility in the short term. For a company like GM with so much going on, that’s almost a certainty.

The total risk is known right up front. It’s just the total entry cost of the trade. Since you’d be buying two contracts, you’d add up the cost of each to find the total risk.

In some cases, this can be a bit more expensive than other strategies. But it can also be much more lucrative.

You see, there’s virtually no limit to the amount of profits this trade can produce. If shares of the underlying stock fall drastically, the put option will gain so much that it more than offsets the loss from the call… and vice versa. The call would be a major moneymaker if shares rally.

The direction, you can see, doesn’t matter… just the degree of price movement.

longstraddle

Source: The Options Industry Council

As you can see, for a situation like this one, where no one can be sure just how good or bad things will get in the short term, this is a perfect strategy.

Let’s look at a specific example of a long straddle trade on GM stock.

A Specific Trade on GM

Right now, a trader could buy a July 19 $33 call on GM for $1.38 per share and a July 19 $33 put for $1.40 per share for a cost of $2.78. Since each represent 100 shares of GM, that’s a total entry cost of $278.

That’s the most the trader would have at risk for the full duration of this trade. But as I noted, the maximum potential profit is nearly unlimited.

If this new tariff continues to wreak havoc on GM’s share price (down 4.4% today so far), the put could very likely skyrocket. Likewise, if either this tariff is somehow scrapped or causes the end of the USMCA, GM could potentially rally. That would leave the call option a much a higher price.

In either case, this play would work out. The only way this play loses the full amount at risk is if shares somehow sit idle at $33 for the next seven weeks… a very unlikely possibility.

To find out exactly which price points this trade enters profit territory, apply the total cost to the strike price.

For instance, shares would have to rise to above $35.78 for the call to have an intrinsic value higher than the cost ($33 + $2.78 = $35.78). Shares would have to drop below $30.22 for the put to outgrow the cost ($33 – $2.78 = $30.22).

In either case, that price movement represents a change in GM share price of 8.4%. That might sound like a lot. But consider what GM’s shares were doing even before this new mess.

Screen Shot 2019-05-31 at 2.08.41 PM.png

From just the last week in March to the middle of April GM jumped 10.1%. Since then, shares have fallen 17.3%. Considering all of this price movement predated this new tariff plan, a smaller movement of 8.4% in one direction or the other is definitely likely. And anything more than that is pure profit.

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