New Trade $HD – Home Sweet Home

Here is a summary of what I will be discussing on Options Action tonight on CNBC at 5pm:

I discussed earlier this week my current distaste for the XHB. I see strong arguments for a pullback in the housing-related complex, both from a technical and fundamental perspective. Home Depot is a classic single stock example of this phenomenon.

As my first piece of evidence, I present the 10 year chart of HD’s P/E:

10 year chart of HD P/E, Courtesy of Bloomberg

This chart includes the entire period of the U.S. housing boom, when HD P/E never reached above 20, in spite of earnings growth in some years exceeding 20%. Home Depot has no doubt executed quite well, consistently turning 5% sales growth into 20%+ earnings growth over the last few years. But with projected sales growth around 15% for the next couple years, a P/E of 23 for a $100 billion market cap home improvement retailer is optimistic to say the least.

Now the obvious question you should be asking is, that’s all well and good, but the same argument has applied for the past 6 months, and HD keeps making new highs. Why is now the correct time to anticipate a pullback? Let’s discuss…

Here is the 20 year chart of Home Depot:

[caption id="attachment_22516" align="alignnone" width="615"]

20 year chart of HD, Courtesy of Bloomberg[/caption]

HD is only $3 away from its all-time high, and that fact alone is likely to bring out some profit-takers in this area, happy to lock in their extraordinary gains from the stock’s amazing run in the past year and a half. At the least, the risk/reward of playing for a pullback here is quite attractive.

Moreover, from a fundamental standpoint, I think the multiple attached to retailers and homebuilders is likely to decrease over the course of 2013 as the U.S. consumer is faced with increasing headwinds. The payroll tax hike to start the year is the first obvious one, but sequestration budget cuts as well as the simple fact that we’re later in the business cycle, without the benefit of bottled up spending, could hurt consumer spending growth later in 2013.

TRADE: Bought the HD ($66.92) May 65 / 60 Put Spread for $1.22

-Bought 1 May 65 put for $2.06

-Sold 1 May 60 put at $0.84

Break-Even on May Expiration:

-Profits of up to 3.78 between 63.78 and 60, max profit of 3.78 at 60 or below

-Losses of up to 1.22 between 63.78 and 65, max loss of 1.22 at 65 or above

Trade Rationale:

Since implied volatility on HD is relatively cheap, around 20, it was not expensive for me to go out more than 3 months to buy the May put spread, which gives me plenty of time to wait for a pullback down to the 60 area, which is strong support. It is a bit more costly for me to buy May put spreads as opposed to March or April, but I want to give myself some margin for error on timing the pullback given how strong the uptrend has been in the stock.