Playing Defense With L-3 Options

That defense stocks would rally as the U.S. embarked on the war against terrorism was a given. The real question now taking shape is whether investors will stay positive on them throughout what's sure to be a long, drawn-out campaign.

Even the dogmatic behavior of investors during most defense-stock rallies may not be enough to offset the market's other key themes of disappointment and underperformance (or at least suspicion of such) when it comes to L-3 Communications (LLL), which began to surrender some ground this week.

Waning Enthusiasm

Like most of its peers, L-3 has benefited greatly from the war on terrorism, but as that effort meanders along uncertain lines, investors' enthusiasm may be waning as well. This week, however, questions seem to surround L-3, which makes communications systems used by the military, and the options market is wagering on the scenarios.

On Monday and Tuesday, the stock fell from around $63 to $56.75. On Tuesday, put-buyers came along with wallets open. Put volume alone reached 2,618 contracts, more than double L-3's average total options volume of 1,100, according to McMillan Analysis. That's to be expected when a stock begins to slip as quickly as L-3 has.

What was also developing, though, is significant call volume. L-3's call options traffic topped 3,100 contracts Tuesday, also significantly higher than the average activity in the options.

On Wednesday, that put volume kept cooking, as more than 1,100 contracts with strike prices at or near $50 changed hands. Shares gave up another buck Wednesday to close at $55.75.

That action came after a note from Thomas Weisel Partners said the firm could be in for some weakness as it awaits approval for a secondary offering from the Securities and Exchange Commission.

Defense stocks have enjoyed a miniboom, rising more than 40% since mid-September. Money managers loved them. The war on terrorism, we were told, is going to be a long one. But because it's not shaping up as a massive effort covered 24/7 on CNN, investors shaken by the overall state of the economy are starting to reconsider their positions in defense stocks.

Peer Performance

Money manager David Schultz has been a fan of Rockwell Collins (COL) and Alliant Techsystems (ATK) since late last year, and those stocks haven't been showing any weakness.

That means investors must decide whether they think L-3 has some specific problems that will make it perform worse than its defense-sector peers or if it's just the subject of investor malaise.

Given the state of the stock, much of the call action was probably not dip-buying speculation. Instead, investors who own the shares are more likely thinking that L-3 won't ramp up again unless something big happens. In the meantime, they can sell call options and get paid to wait around a little.

McMillan's Tuesday report also said rumors were circulating that L-3 will miss its earnings estimates when it reports in late July; that alone is enough to make speculators stock up on puts.

Playing these kinds of possibilities is why the options market exists, and watching L-3 for the next few weeks should show whether this corner of the market was the right place to play them.