Trades

New Challenges for Steel Tariffs = Huge Profit Potential

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Steel production in the United States is integral to the country’s history and economic might on the world stage. As far back as Andrew Carnegie, this sector proved just how much wealth and influence it can gather in a relatively short amount of time.

So, when President Donald Trump set his eyes on a vast reorganization of trade around the world, he started with steel and aluminum. Those tariffs are still at the center of the trade war debate.

But before we get into what all has been happening on this front of late, we need to take a look at what this tariff situation has done for the industry since the trade war kicked off.

Early last year, the president imposed a 25% tariff on all imported steel from most of the world. He extended those rates to the EU and both Canada and Mexico. For a time, this set U.S.-based steel companies on fire.

The price of steel in the U.S. shot up. But as you can see, the impact was quickly quelled:

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A number of things started happening after the first few months of these tariffs. First, steel companies went on buying sprees. Their new-found wealth and increased profits spurred them onto large expansion plans. That continues today.

US Steel – the most iconic of this group – recently announced plans to rebuild one of its oldest operations in Western Pennsylvania. The updated facility will combine two processes into one: thin slab casting and hot rolled band production. This is a first of its kind… one that costs $1 billion in new spending.

Nucor Corp (NUE) also recently announced its own $1.35 billion plan to build a new plate mill in Kentucky. This plant is expected to produce about 1.2 million tons of steel plate products starting in 2022.

This influx of new production – though some isn’t online yet – has already driven the price of steel products down. This surge of supply, not from overseas or our neighbors but from the U.S. itself – has weakened the overall economics about the industry.

The other major development since the start of the tariffs on these products was more macro. The global economy started to slow. While it takes a step or two of logic to connect slowing growth in Germany and China, it makes sense. If the U.S. has shrinking markets to sell its goods to, demand for the manufacturing and materials to make those goods falls.

While for Trump, this might sound like a success on the surface – more jobs in steel production in the US with the additional operations and less competition from overseas – it has put the near-term future of the industry on a precarious path.

And then, when things couldn’t get any more hectic for these steel producers – who, by the way, have actually been doing very well in this environment thus far – another giant challenge comes to the forefront… two actually.

First, the World Trade Organization just ruled on the organization’s Article 21 “national security” justification. This is the legalese Trump has used to impose these tariffs in the first place. He has claimed that these tariffs are justified to protect the U.S.’s national security.

The argument has always been somewhat flimsy… but relatively unchallenged. The WTO deciding that this Article can only be applied to situations involving war and armed conflict. Clearly, that’s not the case here.

It’s unknown if or when these tariffs will come up for debate in the WTO or what will happen after they are decided. But the uncertainty adds one more problem for the industry.

The second recent challenge comes from Trump’s own agenda and party. Just today, Republican senators are meeting with Trump about these specific tariffs. They are going to pressure him to relent if he wants to save the USMCA (NAFTA’s replacement trade deal).

Large Republican names like Chuck Grassley, Rob Portman and John Thune are all opposed to the continuation and potential escalation of tariffs for more than one reason. But the one they believe might help sway Trump to calm this trade war down is that as Grassley put it “If these tariffs aren’t lifted, USMCA is dead.”

That’s strong language from someone that’s been a key ally of the President in the Senate. Of course, here too it’s impossible to know what comes next. The president could go along with them to save his U.S.-Mexico-Canada trade deal… or he could turn them down to continue fighting his trade war.

So, it’s tough to make a bet on the steel industry with so much going on. On the surface, it does sound like the industry is in for a weaker 2019 than it had at the start of 2018. But profits are still up. US Steel just reported a great quarter this morning.

Fortunately, there’s a way to play this fast-evolving situation without trying to bet on the direction it will head.

A Strategy For Short Term Volatility

A long straddle is an options strategy that involves buying both a put option and call option on the same stock with the same strike price and expiration date.

This gives the trader the chance to profit from one of the two options no matter which direction the stock heads. The risk is that it might not move enough.

You can see how this trade works here:

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Source: The Options Industry Council

As you can see, the larger the movement, the larger the potential profit. And you can also see that there’s really no limit to how large that profit can be.

If shares of the underlying stock collapse, the put shoots up in price. If shares rally, the call does well.

For steel, this is a great strategy for the insane amount of uncertainty and expected volatility right now. And the company best positioned to play it is Nucor (NUE). The company is the largest U.S.-based steel company with the most at stake here.

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

A Specific Trade on NUE

Right now, a trader could buy a June 21 $55 call on NUE for $2.53 per share and a Jun 21 $55 put for $1.57 for a total cost of $4.10 per share. Since each option represents 100 shares of NUE, this long straddle trade results in a net debit of $410.

That’s the total amount at risk of this trade. The only way the trader would lose that is if shares of NUE stay right at $55 for the next six weeks, an extraordinarily unlikely event.

For this trade to reach a profit, shares would have to sink by the entry cost or rise by the entry cost. So, for example, the put would gain enough intrinsic value to reach an overall profit if NUE shares fall below $50.90 ($55 – $4.10 = $50.90). The call would at prices above $59.10 ($55 + $4.10 = $59.10).

In other words, shares would have to move by just under 7.5% by mid-June. That might sound like a lot, but consider that this is the company’s last six months of trade:

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Now, consider that Donald Trump is the one that has the power to decide what happens with this industry over the next few weeks. Whatever your opinion on the president, he doesn’t shy away from making waves. Those waves, in this case, could turn to your profit.

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