In previous option trading blogs I have shared my approach to trading sharp market declines. In the first phase I patiently watch for the market to start showing some signs of support. Knowing that the “second shoe” might still drop, I seek “value”. My intent is to add probability to the play by selling out-of-the-money (OTM) put credit spreads. During these nerve wracking periods, I don’t rush to put everything on at one time, I scale-in knowing I may be early and I will probably take some “heat”. This week I shared one of my ideas with Barron’s.

First a quick comment on Barron’s. It is an excellent source of financial research. The content is “rich” and their perspectives are unique. They are expanding their option coverage and soon they will be introducing daily commentary in the online publication. You should consider using it.

The play involves a defense contractor – Armor Holdings (AH). My rationale is that even if the US has an economic downturn this company will still prosper for a few reasons. We are still at war in Iraq/Afghanistan and the chance of a withdrawal announcement in the next few months is unlikely. Tensions throughout the Middle East are elevated. In the US, we are trying to secure the Mexican border. Armor Holdings manufactures security products and vehicle armor systems for the law enforcement, military, homeland security, and commercial markets. The demand for it’s products will continue to be strong regardless of the economy given the current events.

From a fundamental standpoint, the company is in a “sweet spot”. The revenues and earnings have been on a steady growth pattern. As a result the balance sheet is very strong and Current Assets exceed Total Liabilities. AH decided to put some of its cash to work and it is acquiring Stewart & Stevenson – a tactical vehicle manufacturer for the military. It may also use some of the cash to buy-in shares. This year the company is slated to have EPS of $4.38 which yields a forward P/E of 12.1.

Technically, the stock has performed well. In December of 2004 it got ahead of itself and peaked at $50. The company continued to post impressive results and after a year of price consolidation the stock broke through the $50 level in February. It ran all the way up to $64 before conceding to the market sell-off. The $50 level represents support and it will factor into the game plan.

In times of uncertainty, I look for islands of strength. In this case, I have a stock that I feel will post strong earnings. I feel that for the next few months there is a low probability of a news event that will materially change the demand for its products. I like the stock fundamentally and I have a technical support level that I can “hang my hat on”. The company has drifted lower with the market and with the other defense contractors so it may still move lower. It has shown a willingness to rally during the recent market bounces, indicating buying interest.

Here is the trade given that opinion. I will sell the AH August 50 put and buy the AH August 45 put for a net credit of $1.00. My risk is the difference in the strike prices less the credit I received, $4.00 (50-45-1 = 4). In this case, I am risking $4 to make $1. However, I’m not actually willing to risk $4 or assignment. If the stock trades down to $49.50 and demonstrates a clear breach of the $50 level, I will buy in the 50 puts and sell the 45 puts at the market. Even at $49.50, the risk of assignment is minimal since the August 50 puts will still carry time premium. The extent of the losses will be a function of how much time has elapsed and how sharp the drop is. The more time that passes and the more gradual the decline, the better.

If the stock never trades down to $49.50 and it closes above $50 on August expiration, I will stand to gain a handsome 25% return in 2 months. If the stock is between $49.50 and $50.00 at expiiration remember to buy-in the August 50 puts. A return like this does not come without risk.

As I mentioned earlier, I am scaling into positions like this, expecting that I might be early or the “second shoe” might be ready to drop. That is why I’m giving myself breathing room. I also know that if the market does bounce, even a little, spreads like this will vaporize quickly as the stocks rally and the IV’s drop. When the market rally is underway no one will be anxious to take the other side of these trades. That is why you have to start putting positions on “early”.

I have not taken into account anyone else’s risk tolerance, trading suitability, experience, portfolio or tax situation. The position should represent a small (less than 5%) portion of your speculative risk capital. This is simply my own trade consideration. I’ve had many subscribers ask for an actual trade example and I hope this helps.

If you have any comments or questions, please contribute.

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