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During his farewell address in 1961, President Dwight D. Eisenhower noted the strengthening ties between the U.S. military and its equipment suppliers. The more the military expanded, the more the U.S. government had to purchase from private defense contractors.
Eisenhower referred to this relationship as the “military-industrial complex.” Its large and growing power worried him.
These days, few industries are more powerful — and generate more revenue — than the U.S. defense sector. I’m talking about the makers of fighter jets, submarines, aircraft carriers, missiles, tanks and the like.
The U.S. spends more on defense than China, Russia, France, England and India combined. You could say defense spending is enjoying a permanent bull market.
After all, when times are good, the government funds the military. When times are bad, the government still funds the military. The perceived threats to national security don’t go away when recessions hit. This funding consistency means defense contractors can always count on new orders and steady payments coming in from the government.
Investors have taken notice…
The stock returns generated by top defense contractors Northrop Grumman (NYSE:NOC), Raytheon (NYSE:RTN) and Lockheed Martin (NYSE:LMT) have blown away the broad market’s returns over the past 20 years.
Having the Federal government as a “sugar daddy” gives defense stocks an edge. That’s why our antenna always perk up when we see them sell off. Nothing is more attractive than stocks with a fundamental edge that are selling at a discount.
How to Trade the Stochastic Indicator
One tool we use to see when stocks are oversold is a technical indicator called the “stochastic indicator.” This indicator is constructed by studying a stock’s closing price on a given day in relation to the stock’s recent price history.
The stochastic rises when the stock is doing well, and it falls when the stock is doing poorly. Since the financial markets tend to “mean revert” — and overshoot to both the upside and the downside — we can watch overbought/oversold stochastic readings to spot trading opportunities.
A deeply oversold stock or sector is a lot like a basketball being held at the bottom of a pool. When you let go of the ball, it can shoot much higher in a short time.
You know things are extremely bearish, and have probably gone too far, when the stochastic drops below a reading of 20. Whenever you see this happen, especially during an uptrend, you know you may soon have a buying opportunity on your hands.
However…and this is important…it’s not the stochastic dropping below 20 that gives you the buying opportunity. It’s when the stochastic climbs back above 20, after having been below that level, that gives you the buying opportunity.
In other words, we want to see a price extreme in one direction… but also the early indications of a “snap back” move in the opposite direction. We want to get the short-term trend on our side… and avoid getting in front of runaway trains.
Looking at the weekly chart of the iShares U.S. Aerospace & Defense ETF (BATS:ITA) in the image below, you can see that ITA has dropped below 20 and climbed back above that level six times since the bull market started in 2009.
If you had bought ITA each time the stochastic climbed back above 20 and then sold the ETF after the stochastic had first climbed above 80 and then dropped back down below 80, you would have made an average return of 9.7% per trade with an average holding period of just over 19 weeks.
If you annualize those gains, it results in an annualized return of 28.7%. Those are fantastic results. However, with the intelligent use of options, investors can magnify these returns 2X, 3X and beyond.
The stochastic has once again dropped below 20 on ITA. It hasn’t risen back above 20 yet, but a great options trading opportunity has developed on one of the components of ITA: United Technologies (NYSE:UTX).
From a technical perspective, UTX dropped down to its long-term, up-trending support level at $120 and is staging an impressive post-earnings rally. We are looking for the stock to climb back up toward resistance around $132.
Considering this fantastic fundamental and technical set up, it’s time for traders to get long UTX.
To get all the details and see exactly how we are trading this situation with options — and to get access to our full portfolio of promising trades — consider signing up for risk-free trial subscription to Strategic Trader today.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of Strategic Trader.
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