New Trade $LULU: See-Through See-Saw

by Enis June 11, 2013 1:51 pm • Commentary

We like to consider ourselves opportunistic traders.  We’re willing to trade in either direction, long or short options, if the risk/reward is right and the pieces of the puzzle fit.  So when it comes to a name like LULU, today’s massive 16% move lower piqued our interest.  Was there a solid risk/reward opportunity that fit our varying views?

As far as the fundamentals go, I expressed my concern on valuation in the Earnings Preview yesterday:

While the technicals look attractive, the valuation looks very, very stretched.  Whether we use price/earnings (around 45x, with expected growth of 15-30% over the next few years), price/sales (8.6x, far above other retailing cult stories like KORS at 5.5x or UA at 3.3x, and even approaching TSLA, at 12.5x; LULU isn’t exactly comparable on the revolutionary spectrum to TSLA), or market cap per store (around $50 million per each store), the valuation looks extremely rich.

Investors in the stock are clearly betting on the stock to grow into its valuation, but the bar seems to be set very high in this name, with little margin for error.

Today’s selloff has made the valuation a bit more reasonable, though it’s still stretched relative to most apparel companies.  Having said that, I also mentioned the high short interest and concentrated ownership:

Short interest has moved quite a bit higher over the last year, to new 4 year highs, now at around 23% of the float:

5 year chart of Short Interest in LULU, Courtesy of Bloomberg

5 year chart of Short Interest in LULU, Courtesy of Bloomberg

The top 5 shareholders own about 63% of the shares outstanding.

So a poor fundamental backdrop with a strong technical backdrop.  So what’s the trade?

LULU’s huge gap has taken it back into a range in which it traded for most of the time between Sept 2012 and Apr 2013:

[caption id="attachment_26910" align="alignnone" width="634"]1 year daily chart of LULU, Courtesy of Bloomberg 1 year daily chart of LULU, Courtesy of Bloomberg[/caption]

The 65-75 range that I highlighted captured most of the price action over that period, with a large number of buyers and sellers now seeing the stock back to where they first got involved.  In that sense, even with today’s large drop, buyers and sellers over the last year are on average flat in this stock.

With no clear winners on this back and forth tug of war, and LULU implied volatility still near 40 because of today’s large drop, here’s the trade:

TRADE: LULU ($68.70) Buy July 65 / 70 / 75 Call Butterfly for $1.10
  • Buy 1 LULU July 65 Call for 5.43
  • Sell 2 LULU July 70 Calls at 2.80 each or a total of 5.60
  • Buy 1 LULU July 75 Call for 1.27

Break-Even on July Expiration:

  • Profits of up to 3.90 btwn 66.10 and 73.90, maximum gain of 3.90 at 70
  • Losses of up to 1.10 btwn 65 and 66.10 and btwn 73.90 and 75, with max loss of 1.10 at or below 65 and at or above 75

Payout Diagram:

[caption id="attachment_26917" align="aligncenter" width="505"]Screen Shot 2013-06-11 at 11.56.05 AM from TradeMonster[/caption]

70 is the sweet spot on this trade but it also gives decent room in the stock to the downside as 66.10 is the point where it becomes a loser on expiration.

Trade Rationale:  This structure takes advantage of the high implied volatility in LULU, which is why the risk/reward for the fly is quite attractive.  LULU can of course move outside of the 65 to 75 range that we’ve defined, but given that we’re only risking 1.10 to make multiples of that is an indication of the appealing nature of the trade.