With so many good trading narratives to choose from in 2018, traders may be feeling a bit like a kid in a candy store.
While we all find opportunity in different places, I have been particularly fond of trading the steel sub-sector in recent years. As the name implies, the steel sub-sector is comprised of a relatively small group of "optionable" companies producing steel in the US and abroad.
It also happens to be a sub-sector that took center stage in the financial news when President Trump announced earlier this year that new tariffs would be introduced in the United States on imports of steel and aluminum. While the complete vision of the President’s trade strategy isn’t yet clear, the new tariff policy produced economic ripples throughout the world.
On today’s blog post, I am outlining a sample trade I constructed in the steel sub-sector which helps illustrate how trading assumptions are developed and deployed. This example is being used for illustrative purposes only and should not be interpreted as advice or a recommendation.
Background on Steel Tariffs
Historically, the production of steel has been synonymous with the industrial might of the United States. Whether it be skyscrapers, bridges, or railroad tracks, American steel has been an integral component in the modernization of the United States and the broader world.
Unfortunately for the United States, the “age of outsourcing” pushed a great deal of industrial manufacturing (like steel) to lower cost regions of the globe - places such as Brazil, China, and India. Labor costs outside the United States simply aren’t as high, and as a result, many manufacturing jobs have been lost.
Today, many of the states in the Midwest and Northeast that used to be heavily involved in manufacturing steel and other industrial products are now referred to collectively as the “Rust Belt.” And while this nickname was first used to reference the deterioration of economic productivity in the area, it is now often used to reference a strategically important part of the American electorate.
As economic conditions worsened in those states in the last decade, the residents sought new ideas to help lead them through the revitalization process. In that regard, the Rust Belt became a sort of battleground for the country’s biggest political parties.
With the 2018 midterm elections right around the corner, it may be more than just a simple coincidence that President Trump introduced the steel tariffs at this juncture in his tenure. After all, the theoretical beneficiary of steel and aluminum tariffs would, of course, be none other than residents of the Rust Belt.
As you probably already know, tariffs are taxes levied on goods that are imported into a particular country. Under President Trump’s plan, that means imported steel is now 25% more expensive, and imported aluminum is 10% more expensive due to the duties which must be paid on arrival. That theoretically gives US-based producers of the metal a fresh competitive edge.
The above means that if Company ABC in the United States uses a foreign supplier of steel, the cost of purchasing steel from that supplier just went up by 25%. And for Company B that uses a foreign supplier of aluminum, the cost just went up by 10%.
Given that new economic reality, it's not hard to see how a tariff of this type harms foreign producers of steel, and as a consequence theoretically benefits US-based steel manufacturers.
But there are a couple other wrinkles in this narrative that must also be kept in mind.
First, one must understand that sovereign trading partners often respond in kind when protectionist measures such as tariffs are adopted. This instance is no different, and protectionist rhetoric around the world has spiked significantly in the wake of President Trump's tariff announcements.
If other countries decide to levy tariffs on goods they import from the United States, it's not difficult to see how the rising costs of goods (via tariffs) worldwide could contribute to an overall slowdown in international trade. This is because the tariffs effectively represent an increase in the cost of goods (supply side), which means that unless demand picks up enough to compensate, worldwide trade volumes could decrease.
Likewise, it’s not difficult to envision how decreasing trade would affect the business prospects of many publicly traded companies, and in turn the respective economic productivity (i.e. GDP) of the affected countries.
In sum, this means that while the intent of the tariffs may be justified, the net result could be a deterioration in the global business climate. For US-based steel producers, that means that potential positives from reduced foreign competition could get canceled out by a slowdown in orders.
As if all of that weren’t enough, there's another important item to keep in mind regarding the steel and aluminum tariffs.
As it relates to steel, Trump decided to grant exemptions to certain countries - meaning they could operate business as usual without paying the tariffs. Several of the countries and regions initially exempted from the steel tariffs included Canada, Mexico, and the European Union. These three also happen to be among the top four exporters of steel to the United States in total volume.
The aforementioned exemptions were originally set to expire on the first of May, but the White House announced on the last day of April that the exemptions would remain in place for another month (or so). Obviously, the exemptions make this situation even more complicated, because they arguably take the “bite” out of the tariffs, especially those most relevant to the American economy.
Steel Sub-Sector Overview
There are roughly 25 symbols on US exchanges that are traditionally included in the steel sub-sector and also have listed options.
The list below includes most of the medium and large-cap companies within the steel sub-sector, as well as one of the best-known steel ETF’s:
ArcelorMittal (MT) - Luxembourg
Nucor Corporation (NUE) - United States
POSCO (PKX) - South Korea
Tenaris (TS) - Luxembourg
AK Steel (AKS) - United States
Commercial Metals Company (CMC) - United States
Gerdau (GGB) - Brazil
Steel Dynamics (STLD) - United States
US Steel (X) - United States
Worthington Industries (WOR) - United States
Reliance Steel and Aluminum (RS) - United States
VanEck Vectors Steel ETF (SLX)
The list above also includes the respective headquarters of each company to help differentiate US-based producers from foreign producers - an important distinction with regards to the tariffs. Additionally, it should be noted the SLX is comprised of both US-based producers and foreign producers, and is trading not far below 52-week highs.
Building a Trading Assumption (Example)
If you haven’t reviewed the price charts of symbols in the steel sub-sector recently, it’s worthwhile to envision where you see them currently trading. Do you think US-based producers have rallied in the wake of the tariff announcements? Do you think the stock prices of foreign producers have dipped?
In answering those questions, we also have to keep in mind that each of the companies in the steel sub-sector is its own entity - meaning there are varying degrees of management efficiency in the industry, and varying degrees of success at producing a profitable enterprise.
US Steel (X) is one of the best-known names in the sub-sector, and looking at its price chart over the last few months provides some insights into the tariff narrative.
It may not surprise you to hear that X trended up toward its 52-week high immediately prior to Trump’s tariff announcement. However, in the aftermath, X dropped from the mid-$40s all the way down to the low-$30s. That’s not likely what Trump (or the steel industry) was hoping for when the tariffs were initiated.
Is the rally and subsequent crash in X indicative of the fact that investors were disappointed by the veracity of the tariffs? Perhaps. It’s also possible that the exemptions weren’t anticipated, which effectively make the tariffs null and void for some of X’s biggest foreign competitors.
Additionally, we have to consider that this period also includes an earnings announcement by X (on April 26th). US Steel dropped from roughly $37/share to $32/share in the wake of earnings, which were clearly a disappointment. However, some of that drop may be attributable to inefficiencies in the company’s operations, as opposed to the tariffs.
Either way, let’s now look at the performance of a foreign steel producer over this same period. Tenaris (TS), based in Luxembourg, is currently trading right at its 52-week high. Given the downdraft observed in X, this definitely seems like a surprise.
However, we have to keep in mind that the EU (of which Luxembourg is a part) was exempted from the tariffs for the time being. TS announced earnings on April 26th, a report that was received far more optimistically by the market than X’s report. After earnings, TS jumped from about $37/share to $38/share. Again, this may have less to do with the tariffs, and more to do with business factors specific to TS, but it does provide another important data point.
After looking at the price charts of X and TS, we have learned a bit more about the impact of the tariffs on the steel industry, but more information is needed.
Let’s expand our view by examining Nucor (NUE), a US-based producer, as well as Posco (PKX), a South Korean producer.
Interestingly, a similar pattern is observed - NUE has dropped off its 52-week high of roughly $70 in the wake of the tariffs and is currently trading in the low $60s. PKX, the South Korean producer, is trading just under its 52-week highs, more like TS.
Just for fun, let’s throw in two more names. ArcelorMittal (MT), a foreign producer, and AK Steel (AKS), a US-based producer. Once again, the pattern holds - although MT has come off its 52-week highs more than TS and PKX, a look at AKS shows the carnage in the US-based producer has been far greater.
While only a research analyst that specializes in steel might know the exact reasons for the patterns we’ve observed, we can at least surmise from this analysis that the market hasn’t viewed the steel tariffs as a big positive for US-based steel producers. That, or the foreign producers are perceived to be operating more efficiently.
One other important takeaway is the importance of the tariff exemptions, which could have synthetically buoyed the values of producers from those exempted areas. As stated earlier, those exemptions were set to expire on the first of May, but were instead delayed another month (or so).
A Sample Trade in Steel
Taking all of the above into account, my goal in recent weeks was to get long (directionally) in one or more US-based producers of steel.
For one, I thought that the looming expiration of the tariff exemptions could provide a boost to US-based producers. Additionally, I believed that the political will of the White House would at least protect US-based producers from further downside risk. Both of these were personal assumptions on my part, and shouldn’t be interpreted as advice or recommendations.
With midterm elections on the horizon, it’s my belief that President Trump will do everything in his power to lift the US steel sub-sector in order to win the hearts of voters in the Rust Belt. The President made that abundantly clear with the introduction of the tariffs in the first place. I don’t believe he’ll give up on this initiative until he achieves his goal, or the elections come-and-go before he’s able to complete the task.
In the aftermath of X earnings, when the stock dropped from approximately $37/share to $32/share, I believed an opportunity had presented itself to finally get long in the sub-sector.
The trade that I deployed was as follows: Rather than buying the stock outright, I opted to sell 20 of the $32 strike puts in June expiration for $2.25/contract. I chose to sell puts over buying stock because I thought there was an equal chance that X could trade sideways in the near-term, and I felt the short put better fit my outlook. IVR was also above 50% in X at that time, which contributed to the decision.
Because I initiated this trade on April 27th, we have the benefit of looking back at what actually transpired in the days since.
Fortunately for me, X did in fact rebound on Monday April 30th, when it rose more than $1.50 and closed near $34/share. This may have been partially due to post-earnings relief, or it may have been in anticipation of the tariff exemptions being eliminated (a decision that was due the following day).
Whether it was because Trump extended the exemptions, or because the market went south and brought US Steel with it. X dropped back to around $32/share on May 1st - not the preferred direction for my position by any means.
Fast forwarding several days, we see that X rallied once again. On May 4th, US Steel rallied $1.61 to settle the week at $34.52. This was another nice move for my position, and I decided to close it during the last hour of the day on May 4th for a nice profit - I bought back my 20 short contracts on the June $32 line for about $1.10/contract.
A part of my decision to trade had been based on the upcoming expiration of the steel tariff exemptions, which I believed might provide a boost to US-based producers.
Although the trade ultimately went my way, I decided to close it (and not ride it out to expiration) because the tariff exemptions were extended. This action by President Trump affected the underlying basis of my trade, and I therefore elected to take my profits off the table, while re-evaluating my strategic outlook based on recent developments.
Volatility in the steel sub-sector is only one example of the many trading opportunities that have materialized in 2018. The United States is currently negotiating new international trade deals with many of its highest volume partners, and there’s sure to be numerous places that traders can identify market mispricings in the coming days, weeks, and months.
The position outlined in the steel sub-sector today (short X puts) was intended to help illustrate how traders build assumptions, as opposed to highlighting a specific trade in a particular sub-sector. The sample trade in X explored today does not represent financial advice or a recommendation to trade.
Going forward, you’ll be coming across many new trade ideas in underlyings which you haven’t traded in the past. In those cases, it might be prudent to mock trade (paper trade) such ideas prior to deploying them “live.” By doing so, you can monitor how they behave, and build both confidence and experience for trading them “live” in the future.
You should only enter positions when you are 100% comfortable with the exposure and confident in your ability to manage it successfully.
If you ever have any questions about building trading assumptions, or any other trading-related topic, we hope you’ll leave a message in the space below, or reach out at your convenience by emailing us at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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