As the stock market continues to whipsaw back and forth, everyone remains tuned to the president’s Twitter feed. The ongoing trade war with China looks to be intensifying as billions in new tariffs – above those in place over the last year – get added to the pile.
Just this week, we’ve seen the Dow drop more than 600 points yesterday only to recover about half of that in early trading today. The end is nowhere in sight, according to most speculators and market watchers.
Headlines like “Why the Stock Market Today Faces Greater Risk Than Dotcom Bubble” and “Trump’s Trade War with China Could Cause a Stock Market Crash” are flooding financial media right now. Worse, it appears consumer confidence is finally taking its long overdue fall:
Source: OECD Data
While it may be too early to know exactly how any of this will play out, a few industries have already been feeling the pressure. All eyes remain on the ones directly targeted by these tariffs with China and the EU – cars, steel and aluminum and agriculture products. Anyone who has been studying these industries have seen the volatility of the overall market only more intense there.
But these aren’t the only areas affected by a protracted trade war. In fact, others are only now in danger of starting to feel the impact.
U.S. housing is a near impossible industry to really pin down. Despite what “experts” claim, it doesn’t move all in one direction at a time. It is fragmented by region, local economy and jobs. Taxes are another important aspect. But there’s one more… building costs.
Tariffs could begin to play a heavier roll in this side of the industry. Raw goods like steel and aluminum have been at the center of the trade war. But less than 1% of building costs come from those materials. Most new houses are still much more reliant on wood prices. Though, multi-resident housing does rely a bit more on those other materials.
Fortunately for both home builders and home owners looking to renovate their places, lumber costs haven’t been as dire of a problem as some thought they would be:
As you can see, costs have actually come down during this trade war. But that too isn’t a permanent fixture.
Trump’s escalation of tariff talks has angered many economists, investors and opposition politicians. But his own party hasn’t remained uniformly behind him either. The signs of a party split over the prospect of even more tariffs have caused some like Senate Finance Chairman Chuck Grassley to call for a policy change.
The congressman has even visited the White House to talk Trump down. He and several of his colleagues have said that the steel and aluminum tariffs Trump has imposed worldwide could even kill his NAFTA replacement deal with Canada and Mexico.
For housing, this might have even more impact than the steel and aluminum tariffs themselves. You see, we do import lumber in the U.S… from Canada. Lots of it.
This hasn’t escaped this Administration either. In November 2017, a 21% tariff was put on softwood lumber from Canada, resulting in between $6,000 to $10,000 in additional building costs for a median-priced home according to the National Association of Home Builders.
Now, again, it does seem impossible to try and predict how exactly all of this will pan out. But one thing is for sure: investors don’t want to wait to find out. In fact, we see one clear target for their dislike of these policies.
Home Depot (HD) has been one of the best market performers over the last few years. The company has continued to grow its top and bottom lines, as it integrates both its “Pro” customer segmentation and its online-store-pick-up sales channel.
But an increase in material costs, scared homebuilders and owners and an investment environment that shows no mercy could begin a painful share price decline.
Next week, the company will announce its first quarter earnings. While analysts remain somewhat optimistic about recent performance, the real test will be if Home Depot can affirm its guidance for the rest of the year. With all that is on the table, it may be extremely difficult for the company to do.
Any hint at a less than perfect situation at the company would likely result in a short-term selloff. This sets us up in a perfect position to sit on a quick in-and-out profit on Home Depot shares… but only with the right strategy.
A Strategy to Play Home Depot’s First Quarter Announcement
A bear put spread is a type of options trade that involves buying one put option with a strike price close to the current price of the underlying stock and selling a second put with a lower strike.
This results in a net debit, but a smaller one. The upside of this kind of trade is capped by the sold put, but the risk-reward potential – especially when used on stocks like HD – greatly favor traders using it for short-term situations like an earnings period.
You can see how this play works here:
Source: The Options Industry Council
As you can see, both the risk and the potential profit is known right up front, making this a more conservative bearish trade than simply buying a put option outright or shorting shares themselves.
Let’s look at a specific example to see just how this kind of strategy might play out for Home Depot ahead of next week’s crucial earnings announcement.
A Specific Trade For HD’s Crucial Earnings
Right now, traders could buy a June 21 $190 put on HD for $5.19 per share and sell a June 21 $180 put for $2.14 per share for a cost of $3.05 per share. On the 100 shares these puts represent, that’s a total net debit of $305.
That’s the most the trader would stand to lose. He’d only lose it if Home Depot somehow surprises all analysts and investors with exceedingly positive results and forecasts. With so much swirling around the homebuilders and materials industries, that’s not likely at all.
To find just how much this trader would profit, take the difference in strike prices ($190 – $180 = $10), and subtract the entry cost ($10 – $3.05 = $6.95). Again, on 100 shares, that’s a killer profit potential of $695 total.
Now, shares of HD would have to drop somewhat significantly to collect this full return. But that too is not out of the question.
For the trader to max out his profit on this trade, shares of HD would have to fall by 6.3% by mid-June. But considering that shares have already started tipping that direction, having fallen 6.6% since mid-April, this trade is well positioned.