The Options Market Is Ignoring a Way to Play the Trade War

(Bloomberg) -- There's a well-worn playbook for navigating the trade war, but the options market hasn't caught on.

“The price action yesterday was reminiscent of the Q2 2018 period, when tariff worries caused the Russell to outperform the S&P, and emerging-market equities to sell off while U.S. equities rallied,'' wrote Pravit Chintawongvanich, Wells Fargo's equity derivatives strategist.

And yet, in volatility markets, the segments that proved vulnerable last year failed to display any dramatic repricing, creating opportunities for investors willing to bet that they've seen this play before.

Global equities have been battered this week after President Donald Trump's pronouncement, reinforced by U.S. Trade Representative Robert Lighthizer, that the U.S. would escalate tariffs on imported Chinese goods on Friday. Amid the carnage, U.S. stocks have held up better than their global peers, with the most domestic-oriented issues managing to eke out gains on Monday.

Chintawongvanich doesn't expect “an exact replay” of what transpired last year, but noted that the iShares China Large-Cap ETF, ticker FXI, and iShares MSCI Emerging Market ETF, tagged EEM, are likely to underperform U.S. small caps “significantly” in the event that trade talks deteriorate.

He recommends buying puts on FXI, financed by the sale of puts on IWM, the ETF that tracks the Russell 2000. Implied volatility on the Chinese-centric product is cheap relative to its own history and the U.S. domestic-focused gauge, the strategist said.

Industrial companies have played an outsize role in fueling the recent breakout for U.S. small caps, and there's “a legitimate case” to believe these firms are less exposed to risks of breakdowns in cross-border commerce, according to Bespoke Investment Group.

“What is not debatable is that markets were poorly prepared for this,” said Mandy Xu, head of equity derivatives strategy at Credit Suisse. “Investors have been consistently too complacent over the probability of a serious trade war, and we think there is risk to further negative headlines in the coming weeks.''

Implied volatility across a variety of maturities in emerging-market equities was trading at one-year lows ahead of these developments, she said. Indeed, even after Monday's underperformance, emerging-market equity volatility traded well below its 2018 average compared to the Cboe Volatility Index.

Xu advised clients to buy EEM puts on April 29, and now recommends that investors use put spreads to protect against further downside in emerging market equities.

To contact the reporter on this story: Luke Kawa in New York at lkawa@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Randall Jensen, Andrew Dunn

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