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Morning Update

General Dynamics, one of the world’s largest defense contractors, has had a rough start to 2013. The stock initially moved higher with the broad market following the fiscal cliff deal, but has since plummeted 9% from its highs. The selloff has come as investors have digested the slump in defense spending that pushed Q4 GDP negative, a lackluster earnings report, a new CEO, and the potential for a sequester in March. Yesterday put volume was nearly 3 times the average volume, and the biggest trade was the sale of 2500 March 65/60 put spreads for $1.00 with the stock at 66. This is a neutral to bullish position that will profit if GD is above 64 at March expiration. Should GD fall further the spread can lose a maximum of $4 if the stock falls to 60 or below.

The GD’s 2013 low is 64.47, which it has rebounded off of the last two days. This trader is betting that this swing low holds as support between now and March expiration. If it cracks below this level the next stop is 62.00, which was a major support level for the stock in 2012. If this does not hold the stock then it could see a significant move downward to 56.00, which was the 2010 and 2011 lows.

The risks remain significant to the defense sector going forward, and although the stock has fallen quite a bit, buying in here could be like trying to catch a falling knife. That is why this trader chose a fixed risk spread position, which has a fraction of the risk of a short put or long stock position. There is significant event risk in the stock because of the sequester, which is scheduled to take effect on March 1st. If this is not avoided defense funds will be cut by 7.3%. Deputy Defense Secretary Ashton Carter on Jan. 29th said that it is “more likely than unlikely” that the reductions will take effect. Any cuts are likely to cause more selling in the stock, which is why downside risk needs to be kept minimal. Once defense spending is sorted out and there is some certainty GD may be a buy, but right here right now there is no compelling reason to be long because the risk/reward simply does not justify it.

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