Buy Puts as Sector Falls

The killing of Osama bin Laden is a huge victory for America and has brought a heightened appreciation for the U.S. intelligence community. But eliminating this threat may lead to a decline in military spending going forward, and that could be a decided negative for stocks in the defense sector.

Politicians on both the left and the right are calling for an expedited drawdown of troops in both Iraq and Afghanistan, a position already on the minds of the Obama administration. That posture, combined with the realization that the bloated federal budget must be cut, has many on Wall Street believing we’ll see a steady decline in defense spending outlays.

If this does happen, it could be reflected in the stocks of America’s biggest defense contractors including Boeing (NYSE: BA), General Dynamics (NYSE: GD) Raytheon Co. (NYSE: RTN) and others. For options trading investors, that means sector opportunity. Here are six options for a decline in defense stocks. As with all investments, check the bid-ask spreads before launching a trade.

Boeing Company (NYSE: BA)

In addition to budget cuts that could harm its defense orders, plane maker Boeing (NYSE: BA) has also had negative news on its sales to consumer airline firms. A recent report in Aviation Week said a temporary freeze in production of the company’s 747-8 passenger plane could push delivery to customers into early 2012. Boeing disputes this charge, but what they have admitted is that high fuel prices and the social unrest in the Middle East may have an impact on the orders it receives from that region. Boeing has already had 48 cancellations so far in 2011, and the company admits this is higher than average. If that trend continues, look for the stock to come off of the 52-week high it soared to in late April. Options players who think a there’ll be a nosedive in Boeing can look at the BA Jun 2011 80 Put.

 

General Dynamics (NYSE: GD)

The increased profile of special operations forces, such as the now-famous U.S. Navy SEAL Team Six, has raised concerns for the military need of running big, heavy land operations involving equipment like the Abrams battle tank built by General Dynamics Corp. (NYSE: GD). If we indeed see a drawdown in Iraq and Afghanistan the way many analysts suspect, then it could hurt General Dynamic’s tank sales. Last year, the company saw the smallest annual sales increase since 1995, and unless it does something to turn that trend around, the stock could be headed lower. A bet on an eventual tanking of GD shares would be well served with a long-term option such as the GD Jan 2012 75 Put.

Lockheed Martin (NYSE: LMT)

The diversified defense contractor recently reported robust Q1 earnings, but once again, those earnings are tied directly to federal government spending. Moreover, Lockheed Martin Corporation’s (NYSE: LMT) exposure to conventional weapon systems, particularly the F-35 fighter jet, could put pressure on both earnings and the stock price. That downward pressure could find a welcome reflection in the LMT Jun 2011 80 Put.

Northrop Grumman (NYSE: NOC)

 

Another big defense name is Northrop Grumman Corporation (NYSE: NOC), but unlike some of the stocks here, Northrop shares have been on the descent since hitting a 52-week high in February. The decline has prompted Northrop to buy back about $1 billion in shares, which will reduce the company’s shares outstanding by about 5%. So far, the announcement hasn’t done much to move NOC shares higher. If the slide in Northrop continues, aggressive options players can profit with the NOC Aug 2011 60 Put.

Raytheon (NYSE: RTN)

Perhaps more than any other company, aerospace and defense contractor Raytheon Co. (NYSE: RTN) is directly impacted by cutbacks in government military and aerospace spending. The company recently saw a 14% decline in earnings that prompted management to lower its full-year earnings estimates. Raytheon shares trade well below their April 2010 high of just under $60, and over the long term this company’s shares have been bitten by the bear. If that trend continues, then options players will be rewarded with the RTN Jun 2011 49 Put.

 

L-3 Communications (NYSE: LLL)

Defense communications contractor L-3 Communications Holdings Inc. (NYSE: LLL) just received an $84.9 million contract to manage computer systems for U.S. Special Operations Command. That’s the good news. The bad news is that L-3 just reported first-quarter net income that fell 7% as it lost a Special Forces support contract. The company also lowered its revenue outlook for the full year as it forecast a smaller than expected contribution from its government services segment. The poor Q1 results prompted a downgrade from BB&T Capital Markets from “Buy” to “Hold”. If this trend continues, it will benefit holders of the LLL Jul 2011 80 Put.

At the time of publication, Jim Woods held no positions in any of the stocks mentioned in this article.