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This Defense Contractor Could Provide a Triple Digit Gain

This Defense Contractor Could Provide a Triple Digit Gain

Trade summary: A bull call spread in Kratos Defense & Security Solutions, Inc. (Nasdaq: KTOS) using the August $20 call option which can be bought for about $1.48 and the August $22.50 call could be sold for about $0.80. This trade would cost $0.68 to open, or $68 since each contract covers 100 shares of stock.

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  • In this trade, the maximum loss would be equal to the amount spent to open the trade, or $68. The maximum gain is $182 per contract. That is a potential gain of about 167% based on the amount risked in the trade.

    Now, let’s look at the details.

    GlobeNewswire carried the details of a new contract for KTOS.

    The company announced “that Kratos Unmanned Systems Division has been awarded a five-year indefinite delivery, indefinite quantity (IDIQ) contract valued at up to $400 million for the development, integration, and prototype air vehicle delivery in support of the U.S. Air Force’s Skyborg program.

    Work under the program award will be performed at secure Kratos manufacturing and production facilities located in Oklahoma and California over the next 60 months.”

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  • The stock traded higher on the news.

    KTOS daily chartThrough the Skyborg program, the Air Force wants to field a family of unmanned aerial systems that use artificial intelligence to adapt to battlefield conditions.

    The Skyborg drone should be cheap enough where the loss of aircraft in combat could be sustained, yet survivable enough so that it could move into a high-end fight and function as a wingman to manned fighter jets.

    “Because autonomous systems can support missions that are too strenuous or dangerous for manned crews, Skyborg can increase capability significantly and be a force multiplier for the Air Force,” said Brig. Gen. Dale White, who leads the Air Force’s program office for fighters and advanced aircraft. “We have the opportunity to transform our warfighting capabilities and change the way we fight and the way we employ air power.”

    Air Force acquisition executive Will Roper has said that Skyborg could eventually become smart enough that, like R2-D2 in the Star Wars films, it can autonomously present information and conduct tasks to help decrease fighter pilot workload. The system learns from prior experiences how best to support human pilots.

    The company’s announcement continued, “Steve Fendley, President of Kratos Unmanned Systems Division, said, “Skyborg is a critical U.S. Air Force Vanguard program that will ensure the United States maintains our technological dominance in a period of significant nation-state competition and our readiness for the future of aircraft-based warfare.

    Kratos has been and remains committed to advancing affordable unmanned technologies, and we are proud to be a Skyborg prime contractor, helping enable the DoD to significantly increase mass and effect at dramatically reduced cost compared to traditional aircraft programs.”

    The long-term chart using weekly data shown below shows that the recent rally pushed the stock price into resistance. A breakout could signal a large rally is likely.

    KTOS weekly chart

    A Specific Trade for KTOS

     For KTOS, the August options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.

    An August $20 call option can be bought for about $1.48 and the August $22.50 call could be sold for about $0.80. This trade would cost $0.68 to open, or $68 since each contract covers 100 shares of stock.

    The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

    In this trade, the maximum loss would be equal to the amount spent to open the trade, or $68.

    The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

    For this trade in KTOS, the maximum gain is $182 ($22.50- $2= $2.50; 2.50- $0.68 = $1.82). This represents $182 per contract since each contract covers 100 shares.

    Most brokers will require minimum trading capital equal to the risk on the trade, or $68 to open this trade.

    That is a potential gain of about 167% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.

    A Trade for Short Term Bulls

    As with the ownership of any stock, buying KTOS could require a significant amount of capital and exposes the investor to standard risks of owning a stock.

    To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.

    Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

    To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.

    This strategy is designed to profit from a gain in the underlying stock’s price but  the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

    bull call spread

    Source: The Options Industry Council

    Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

    This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.

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