Monday, December 24, 2012

Morning Update

Overnight volumes have been expected light ahead of the Christmas holiday. S&P 500 futures traded down to test Friday’s lows but have since bounced and are down small from Friday’s close. This move has closely tracked trading in the Yen and Euro, with the Yen and Dollar hitting highs as the S&p hit lows. Currency markets should be a good barometer of risk sentiment this week as equities see low volume. Look for the S&P 500 to follow the EUR/USD pair and the USD/JPY pair. When markets reopen on Wednesday morning expect the focus to be on the fiscal cliff again, with Obama’s “Plan B” in the spotlight. The bill Obama is expected to try and pass will likely extend tax cuts for people making less than $250K, increasing capital gains and dividend taxes to 20% and extending unemployment spending through 2013.

On Friday markets around the world tumbled as a bout of risk aversion, driven by Speaker Boehner’s failure to get enough votes to pass “Plan B”, swept markets. One stock that held up surprisingly well was General Dynamics, a defense giant. The S&P 500 ended 0.9% in the red but GD, after gapping down, ended up 0.2% and on its highs. In fact GD closed at its highest level in 6 months and is now decisively above where it was ahead of Obama’s re-election. The stock saw heavy stock and option volume on Friday, with the biggest trade of the day being the sale of 3400 Jan. 72.5 calls for $0.70 against 34,000 shares of stock bought at 70.10. This is a buy-write trade and shows that the trader is bullish on the stock with a price target of 72.5 at January expiration. This trade will profit if GD is above 69.40 at January expiration and can return a maximum of $3.10 if GD is at or above 72.50 at expiration.

A defense company like General Dynamics might seem like a strange stock to outperform the market on a day when fears of going of the fiscal cliff are high, but it is looking like the fiscal cliff will not be as bad as previously thought for the sector. On Friday the House and Senate passed a bill that will give the Pentagon $640.7 billion for the fiscal year that began on Oct. 1st for defense programs. This is $1.7 billion more than President Obama requested, which is why the defense sector has caught a bid. General Dynamics will benefit in particular because the deal includes a contract for a new Virginia class submarine from General Dynamics as well as a contract to continue production of upgraded Abrams tanks for the Army.

This defense bill had bi-partisan support and is likely to be signed by Obama. This provides the future of General Dynamics with some certainty and has given investors the confidence to step back into the stock. I recommend using a buy-write strategy like this trader did because it provides exposure to the stock while limiting the downside and cutting some of the day to day volatility. The market, and defense sector included, is not out of the woods yet and this holiday trading could cause significant gyrations in the market. That said, the January expiration cycle is typically a great time to be short option premium because of the holidays. By selling a call you get to keep the option premium collected no matter where GD is at expiration, and this premium can greatly enhance returns in a choppy market.

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