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Trades

Profit From the Trade Talk Volatility

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U.S.-China trade talks continue to heat up. Trump announced that his administration is going to extend the deadline for new tariff increases as these talks progress. Originally, the two sides were set to hike tariffs on products tomorrow.

Now, this indefinite extension seems to be signaling to some that the two countries are close to a deal.

Of course, we’ve been here before. They have previously sat down to discussions only to part without a deal. So, we can’t know how it will turn out this time around.

With so much left unknown it has some companies and investors quite nervous… no one more so than in the agriculture industry.

We just got the January farm report that showed a slight uptick in U.S. soybeans sold to China from December… but still more than 97% down year over year — from 5.8 million metric tons in January 2018 to just 136,000 last month.

At the same time, as a good faith measure from the Chinese government, it agreed to buy 10 million metric tons of soybeans from the U.S. That sounds like quite a positive. But you can see that doesn’t even cover two months’ worth of sales in previous years.

Fortunately, the talks are going to continue. So, China might still raise that figure. But it is going to clearly have a major impact on companies like Archer-Daniels Midland (ADM), one of the world’s largest agriculture products processors.

Its soybean and corn business downturn has started to hit the company’s top line of late. It’s last fiscal quarter ended on December 31 with a slight drop from $16.1 billion to $15.9 billion. If no deal is reached you could expect that to get worse. However, if a deal is reached, it could put ADM back in business.

Luckily for us, there’s a way to play this uncertainty. We don’t know what U.S. and China negotiators are going to come up with… if anything at all. But we do know that just the very talks will cause ripples in ADM’s stock price.

And there’s a great option strategy for that exact scenario.

A Strategy For Agriculture Uncertainty

A long straddle is a type of options trade that involves buying one call option and one put option with the same strike price and the same expiration date. It sounds strange to bet on both a share price increase and decrease at the same time. But it does make sense.

The play takes the guessing out of the equation completely. We don’t know if a trade deal will get done. But we do know that no matter what comes out of these trade talks, it’ll have a major impact on companies like ADM. So, a long straddle is a way to play that movement without being forced to pick its direction.

The risk of such a trade is known right up front… it’s the money paid to enter the trade. That entry cost – the premiums for both options – is the most a trader using this strategy could lose.

His gains, however, are nearly unlimited. If the underlying stock of a long straddle trade falls in price – say, the trade deal blows up and both sides go ahead and put new tariffs in place – the farther it falls, the higher the put option will be worth.

Likewise, if a trade deal is reached and China goes back to buying as much of the U.S. soybean crop as it wants, shares of ADM should skyrocket. That would make the call a lot more valuable.

In either scenario, only one leg of the trade does well. But in both possibilities, the returns from the winning option far outweigh the loss of the losing option.

You can see how that looks here:

Source: The Options Industry Council

Let’s look at a specific example to show you how such a trade might work on ADM…

A Specific Trade on ADM

If a trader was looking to play this expected movement in ADM shares – but doesn’t want to guess which direction that movement will be in – he could use this long straddle strategy.

He could buy a March 15 $43 call for $0.41 per share and buy a March 15 $43 put for $0.79 per share. That means this trade costs a total of $1.20 per share to enter. Since each option represents 100 shares, that’s a net debit of $120 to the trader’s account.

That’s all he has at risk if Archer-Daniels Midland stock doesn’t move from here. But even that isn’t a total wipe. Since the put option is slightly in-the-money, he could still exercise that by March 15 and get some of his capital back.

But it is far more likely that shares don’t stay where they are at all. As noted, this trade war has been devastating to companies like ADM. And so, all eyes are on these trade talks between the U.S. and China. Something has to give.

Either the two sides agree to terms and companies like ADM are able to sell easily and tariff free with China, great. The call should do well. If negotiations end badly, and tariffs go up, the put option should do well. In either case, this trade could be a winner.

Like we said, potential profits are nearly unlimited. But to find the point at which this trade does turn into a profit, take the entry cost and apply it to the strike price.

For instance, the put option will become valuable enough to make this whole trade a winner if shares fall below $41.80 ($43 – $1.20). If shares go up, this trade hits a profit when ADM shares pass $44.20 ($43 + $1.20).

This represents a move of just 2.8%. You can expect this stock to move much more than that on whatever news comes out of the trade talks.

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