Lockheed Martin Diagnal Call Spread (Update)

Following a poor outlook for FY 2010 earnings provided by management on the recent earnings conference call, LMT's stock price fell considerably on 10/20. In light of this price movement, I defensively repositioned the LMT spread by (i) buying back the 10 December 80s, and (ii) selling 10 December 75s, for a net credit of $1100 less commissions. The position's max profit point is now $75 as opposed to $80.

Lockheed Martin Diagonal Call Spread

Summary: On 10/15 PT entered into a second diagonal call spread, this time using Lockheed Martin Corporation (LMT) stock, which consists of (i) buying 15 March 70 calls, (ii) selling 5 December 75 calls, and (iii) selling 10 December 80 calls, for a net debit of $8615.16. As of 10/16, OptionsXpress expresses the profit/loss profile of this position in the blow chart (which, as discussed in the prior post, should be taken with a grain of salt b/c of an unrealistic IV assumption).



Break-Even Price: Likely around 73 depending on IV at December expiration.

Maximum Profit Price: $80 per share. Note that unlike the McDonald's (MCD) spread, this spread doesn't include additional long calls to capture upside - which sacrifices downside protection and time decay on the MCD spread.

Potential Downside: Downside is limited to the net debit, or $8615.16.

Greeks: As of 10/16, position delta was 468, and gamma -26. Position theta was around 10.7, and will increase as we near December expiration subject to a changing stock price. Vega was substantial at 93.3. For more information regarding the "greeks" please see the McDonald's post.

Rationale: Similar to MCD, I believe LMT is a compelling diagonal call spread candidate. IV on the March calls (and all LMT calls) has declined drastically in recent months. Given concerns regarding the current administration and the federal government's budgetary restrains, the stock trades at a historically low multiple of both trailing and projected forward earnings, and offers a substantial dividend yield. LMT stock has shown strong support in the 70-75 range (which makes sense fundamentally), and has come down modestly over the last few weeks after flirting with the $80 mark. Look for LMT stock to move relatively substantially next week upon the 10/20 earnings announcement. Following the announcement, the position will be reevaluated.

In the event LMT stock declines drastically over the next three months, I will look to add exposure so long as LMT's fundamental strength remains intact. I don't, however, believe LMT has break-out potential given the above mentioned concerns and believe it will likely stay range bound into the forseeable future. The optimal turn of events would be for LMT to stay in the mid to high 70s until December expiration (or at least end there), allowing me to roll the December 75 and 80s into January or February 80s while keeping the March calls.

Note that I've chosen to stagger the expiration of the near month calls in my two diagonal spread positions between November and December, a helpful hedge against market volatility.

McDonald's Modified Diagonal Call Spread

Summary: On 8/13 PT entered into a modified diagonal call spread on Mcdonald's Corp. (MCD), which consists of: (i) selling 10 November 57.5 calls (which were at time of sale, slightly "in the money"), (ii) buying 10 March 2010 52.5 calls, and (iii) buying 3 March 60 calls (hence the "modified" in modified diagonal call spread). The cost of the position, including commissions, is a net debit of $5,173.99. The following chart depicts the profit/loss profile (albeit inflated because of a quirk in the OptionsXpress software which assumes a higher than realistic implied volatility (IV) at expiration).



Break-Even Price: Break-even price at expiration, which will depend on implied volatility (IV) of the March calls, is likely around $56.5.

Maximum Profit Price: Because of the 3 March 60s, profit is theoretically unlimited. Profit at $57.5-60$, depending on IV at the expiration date, would likely be around $1200.

Potential Downside: Downside is limited to the net debit, or $5,173.99.

Greeks: At entry, position delta (or sensitivity to a $1.00 change in MCD stock) is 347.77, and gamma (the decrease in delta due to a $1.00 change) is -43.33 (gamma will in turn decrease as the stock rises due to the 3 March 60 calls). Position theta (the increase in the value of the position in a day, assuming a flat stock price and no change in IV) is 9.7 at time of entry, which will increase as we near November expiration and then decrease as the extrinsic value on the November 57.5s evaporates. As position theta approaches negative, I will look to exit the position or roll the November calls to December. Theta will decrease as the stock rises above or dips below the near-month strike price, 57.5. As with any diagonal spread, vega (sensitivity to IV) is substantial - which will be profitable in the event of a sudden increase in general market volatility (but will result in a decrease of the value of the position if volatility continues to decline over the next month).

Rationale: MCD is a terrific diagonal spread candidate because it's a stable, dividend paying, well managed, and recession "resistant" business, with a compelling valuation at around 15x earnings. These factors create a figurative "floor" on the stock price not too far below current price (52 week low is around $50 per share), and create opportunities for additional trades in the event the shares fall substantially below their current price and valuation becomes even more compelling.

Note that MCD reports earnings on 10/21 which will likely cause a larger than normal increase or decrease in MCD's stock price, and will also result in a decline in extrinsic value of all three options, but disproportionably affect the November 57s. In the event the stock declines drastically following the earnings release, I will look at increasing exposure to the current position, or entering into a similar position at a lower strike price (unless the earnings demonstrate a systemic issue affecting MCD's fundamental valuation).

The ideal outcome here would be for MCD to stay (or finish) relatively flat prior to expiration, allowing me to profit form the decline in the extrinsic value of the November 57.5s, and then roll into the December 57.5s, and so on. A sharp rise in MCD would be profitable but would limit the future potential of this and other positions on MCD given an increased and potentially unsustainable valuation.

On a side note, one way to look at the cost of purchasing an in the money option like the March 52.5s is to compare the extrinsic value to the alternative cost of borrowing funds to purchase the underlying stock. At a value of $6.20 per share, and a MCD stock price of $57.5 on 10/13, the March 52.5s have $1.2 of extrinsic value, and $5 of intrinsic value, which is a 2.2% borrowing cost on the $52 (or about 6-7% annualized once taking into account the effect of the dividend). However, unlike real margin debt, purchasing an option is "non-recourse" - one just pays the extrinsic value (interest), and isn't liable for the entire value of the alternatively borrowed funds. An imperfect analogy to selling short term, at the money, options against long term, in the money, options is borrowing long-term at a low interest rate, and lending short term at a higher interest rate.