How to trade the US-China trade war: A market-beating options strategy

The stock market has come under serious pressure since President Donald Trump raised the stakes in the ongoing US-China trade war.The derivatives strategy team at Wells Fargo formulated an options trade it says can keep investors afloat during these turbulent times — or at least help them lose less money than the broader market.Visit Business Insider's homepage for more stories.Watching the stock market plummet can be a helpless endeavor. After all, the last thing many investors want to do is sell into weakness. So any major sell-off becomes a frustrating waiting game wracked with anxiety.But it doesn't have to be quite so demoralizing. When large market moves happen, disconnects form, which wise investors can then exploit.Pravit Chintawongvanich of Wells Fargo has identified one such irregularity, and it stems from an interesting market wrinkle: Firms with minimal international exposure have historically outperformed during past periods of trade-war strife.The Russell 2000 index — which is heavily weighted towards domestically focused small-cap stocks — is the usual bellwether for this group. And wouldn't you know it, the index has fallen less than the broader market over the past two sessions. In fact, it rose on Monday as other US indexes closed red.Chintawongvanich notes that this behavior also played out in the second quarter of 2018 — the most recent instance where the US-China trade war was the key source of market volatility.The dynamic can be seen in the chart below, which shows the relative performance of an exchange-traded fund tracking the Russell 2000 (IWM) versus ETFs tracking Chinese (FXI) and emerging-market (EEM) equities. As you'll note, IWM easily outpaced the other funds, as well as the benchmark S&P 500.But wait, there's more, and it could make you some money during these trying times. Or, at the very least, it could help you lose less money than everyone else during a turbulent period.Chintawongvanich notes that volatility on the laggard FXI and EEM funds is “trading cheap” relative to a similar measure for IWM. This is surprising to him — and represents an opportunity.“Should trade talks deteriorate, FXI & EEM should underperform IWM significantly,” Chintawongvanich wrote.So he proffers the following options-trading strategy: sell 1x IWM puts at a strike price of $155, and buy 3.7x FXI June puts at a strike price of $41.50.With that in mind, it's important to note that this trade opportunity is only available because investors were largely asleep at the switch.“Markets were poorly prepared for this,” Mandy Xu, an equity derivatives strategist at Credit Suisse, wrote in a client note on Monday morning.Xu firmly agrees with Chintawongvanich's assertion that more price swings are coming. As such, his trade — framed in the context of Xu's outlook — looks like a prudent way forward.“If we do get a serious escalation, there could be further upside to volatility and a more sustained increase in the VIX, as investors are not prepared for this,” Xu told Markets Insider by email on Monday.