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Cramer: Watch these risky trades to track progress in the China 'trade war'

Key Points
  • "Mad Money" host Jim Cramer highlights a trading style that could be useful for investors to watch amid escalating U.S.-China tensions.
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How to track progress in the China 'trade war'

CNBC's Jim Cramer knows that Wall Street's hedge fund managers will undoubtedly have a strategy for approaching the United States' trade debacle with China.

"These hedge funds are putting on what we call paired trades, ... betting against one company with huge Chinese exposure and going long a similar company with little to no Chinese business," the "Mad Money" host said on Friday. "The idea is that whatever the industry, the stock with China exposure is going perform worse than the one without it."

While he admitted that it's hard to pit President Donald Trump — the man behind "The Art of the Deal" — against those who study Sun Tzu's "The Art of War," he wanted viewers to understand how the game is played.

"I want to make it clear that I am not advocating this strategy for you homegamers," Cramer said. "The issue here is that the president is OK with hurting American companies that do business in the People's Republic."

"It implies there will be actual repercussions, earnings per share repercussions, and that is something we are not prepared for from this trade spat, which means hedge fund managers are going to shoot first and ask questions later," the "Mad Money" host continued.

1. Restaurant stocks

The first paired trade Cramer looked at was in the restaurant business, particularly the stocks of Yum Brands and Yum China, the 2016 spin-off of Yum Brands.

The two companies' price-to-earnings multiples are near equal, making them clear targets for a paired trade, he said.

"The pros can short Yum China and go long Yum. If things escalate, it wouldn't surprise me if [China] slaps some duties on Yum China or their state-run media starts going after Pizza Hut or KFC," Cramer said.

Cramer noted that when the Chinese press tears into Yum China, it tends to weaken the company's earnings.

"On the other hand, Yum Brands is doing fabulously in the rest of the world with a possible turn at Pizza Hut ... and steady numbers from surprising Taco Bell," he said. "Put them together and you've got the making of one of the greatest paired trades involving China."

2. Industrial stocks

If the United States places tariffs on Chinese machinery, hedge fund managers could assume that China will do the same to the U.S.-based Caterpillar.

"So these funds would short Caterpillar's stock and go long the stock of United Rentals, the domestic player that rents out heavy equipment," Cramer said.

The trade would ascertain exposure to strong sales and infrastructure spending in the United States, while hedging against risk in China, he explained.

"I can see people doing this, even as I think it's a very dangerous trade," Cramer warned. "If Trump can settle with the Chinese, or even if it simmers down, Caterpillar will take off as the company's doing very well worldwide."

3. Coffee stocks

In the coffee space, Starbucks benefits hugely from its China business, the coffee maker's "chief growth engine," Cramer said.

"I doubt the Chinese would ever retaliate against Starbucks because it's a huge employer that pays its workers well and has a highly respected brand," he said. "But if they get really, really angry, then ... you'll see managers go short Starbucks and go long, say, Dunkin' Brands or McDonald's."

Conclusions

Cramer joked on "Squawk on the Street" about going long Dine Brands' Applebee's and shorting Apple in the same fashion, but he admitted he was being facetious.

"Still, the point I was making stands," he said. "Right now we have a president who doesn't seem to care about what American companies he hurts, including Apple, while trying to get China to change its behavior. For managers who expect a protracted trade war, these paired trades make sense."

But Cramer doubled down on his warning that this kind of trade was too risky for homegamers.

"If Trump manages to make a deal with the Chinese, these stocks will become what we call crowded shorts and you'd be annihilated, which is one reason we never recommend short-selling on 'Mad Money,'" he said. "But if you want to understand how the trade war is going, watch Yum China versus Yum, United Rentals versus CAT, Starbucks versus Dunkin', and even the facetious, fatuous, albeit hilarious Apple versus Applebee's."

WATCH: Cramer pinpoints the trades to watch in a trade war

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Cramer: Watch these risky trades to track progress in the China 'trade war'

Disclosure: Cramer's charitable trust owns shares of Apple.

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