Sunday, December 16th, 2018

Trade War? Buy Options

 

The long-running bull market is starting to weaken. And now, President Trump seems bent on starting a trade war by putting tariffs on steel and aluminum imports. The market’s initial response is to head downward. Will there really be a trade war? And would a trade war hurt the stock market? If so, what should you do? Our suggestion is to buy options to limit your risk as this scenario plays out.

Limit Risk with Options

Hedging risk with options allows investors to stay in the market during periods of volatility.

Hedging risk with options is a common practice of producers and consumers of commodities, companies doing business internationally, and owners of stocks, futures, and precious metals. By buying calls or puts the options trader locks in the equity price and can sell in the case of puts or buy in the case of calls until the options contract expires.

Options traders buy calls to lock in potential profits if a stock appreciates in value and they buy puts to protect against loss if the stock price falls. In the event of a full-fledged trade war it is likely that stocks will fall. Those investors who have ridden the tech stocks to higher and higher gains may wish to buy puts to protect their positions.

A useful strategy for investors is to use puts to preserve stock gains. This approach can be used when the stock price is rising rapidly and when the price is volatile as well.

We used the example of XYZ Corp to explain the use of puts to protect profits.

If the stock holder in XYZ believes that the stock has simply run its course he will sell and take his profit. But, in this case, he believes that new products will drive XYZ to greater heights. And, in the meantime, the stock might still be subject to a huge correction in which he could lose half of his gains in XYZ. What is options trading with puts in this case? It is an insurance policy. The investor will not sell his stock but he use puts to preserve stock gains. If the stock falls in the near future he can do one of two things. He can exercise his put option and sell the stock, wait for it to bottom out, and buy again. Or he use puts to preserve stock gains in a simpler manner. He will can his options contract and continue to hold the stock. The end result will be the same if he chooses to use puts to preserve stock gains in XYZ.

The potential for a trade war is real and thus the potential for a big stock market correction is equally real. The answer to a trade war is to buy put options on stocks that are likely to be hurt. This strategy allows the trader to hold the stock in case this is all a false alarm and to protect profits by exercising the put contract in the event of a dramatic fall in stock price.

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