Options Corner: Trading Opportunity in LMT "Head and Shoulders" Pattern

Diane (0:00)

Vertical Research is upgrading Lockheed Martin to a buy from a hold with a $600 price target. The firm says while there is much uncertainty about the outlook for the US defense budget and area where there is bipartisan support for increased spending, it's missiles. It sees the company's missile division growing by about 11% a year through the end of the decade. Time now for Options Corner. Joining us now, let's take a deeper look at the chart. First up is Ben Watson, Senior Manager of Trading Services, Charles Schwab. All right, Ben, let's get into this chart. Which range should we notice?

Ben Watson (0:30)

Well, good morning, Diane. You know, this is one of those stocks that has, you would think, some upward lift, but it's really kind of rotated into this sideways pattern that we've seen. There was that big push to the upside around the start of the conflict and now you start to see this drift sideways. So maybe too close for missiles. We've got to switch to guns here a little bit. But you look at the short-term head and shoulders pattern that had developed after the last earnings announcement. We're kind of going into that same time frame. That came to completion. It actually moved down to that 490 support level that was the price target. Based on that head and shoulders pattern, now seeing maybe a little bit of a bounce to the upside off of that support that's been tested now once, twice, maybe three times as a level of support, with a little bit of a momentum shift to the upside. Now, 50 period moving average still trailing to the downside off of that resistance up around the triple nickel at that 555 level.

Diane?

Diane (1:31)

Ben, you had me at a loss of words. I was literally taking a drink of water as you were delivering this chart.

All right, let's get into the example, Trey. What you got?

Ben Watson (1:45)

So looking at the fact that we've got that earnings announcement fairly close and that implied volatility is relatively high and potentially falling, not as high as it has been. I went out and this is that awkward period, as Alex Coffey says, where you have to either deal with the earnings announcement or you have to ignore it. And so we're going to go out a little bit beyond this earnings announcement and take that duration of a short put vertical spread, selling underneath that level of support around the 45 strike and then buying a little bit lower. So the expectation is a bullish movement up above that short strike at the 485 level. So looking for the price to continue to bounce off of that 490 support and continue to move higher. If it does that, there is that potential upside, but that upside is limited to the max gain on the vertical spread, which in this case is about $340 on that $5 wide vertical spread. Max risk in there, excuse me, $10 wide.

I moved it to $10 wide, so I got to double check my numbers. $340 on the max gain, max loss on this trade, $660, if it does break down through that $475 strike. But that gives us a break even right around the 481 mark, so we could be wrong directionally, can break that support level, we can still potentially make money or break even in this relatively high probability, fairly low gain type of trade. Diane.

Diane (3:15)

Then Ben, you mentioned going out beyond earnings here, so you say you have to either ignore it or, I forget what your other option was here. So what do you do? What's the risk management here for this example trade?

Ben Watson (3:31)

Well, the reality is you've either got to take a shorter duration trade and deal with the trade-off which is less premium and greater risk of volatile movement because you've got that earnings announcement as an event risk, or you go out beyond that date and give yourself a little bit of duration, still take a little bit of elevated implied volatility knowing that you've got the potential for a volatility crush post the earnings announcement, which may benefit a short vertical spread like this, which is a short trade selling premium.

That Vega crush definitely helps that trade theoretically, but this becomes a high probability trader as we might think about a target-rich environment. Diane.

Diane (4:15)

Okay. Our colleague Keith reminded me what you said. The other option was to deal with it.

Thank you, Ben. Appreciate that. Ben Watson, Senior Manager of Trading Services, Charles Schwab.