New Trade – $COST Conscious

by Dan July 9, 2015 12:40 pm • Commentary

Costco (COST) has executed fairly well in a difficult retail environment, and backing out their exposure to a strong dollar (30% of their sales come from outside the U.S.) and weak fuel prices the company has posted impressive same store sales, despite headline misses.  I have routinely been skeptical of its premium valuation to competitors Target and Walmart, with COST trading at 25x expected fiscal 2016 earnings growth of about 10% on 8% expected sales growth, which would be up from 4% in 2015.

Since making new all time highs in early February, prior to the company paying out a $5 special dividend, the stock has been in a steady downtrend, down about 11% from the highs, but still up about 1% on the year, and up 20% from the 52 week lows a year ago:

COST 1yr chart from Bloomberg
COST 1yr chart from Bloomberg

I would note that the stock bounced very nicely from $135 to $140 over the last few trading days, but today it got rejected at the converging 50 (purple line) and 200 day (yellow line) moving averages.  Some would call the 50 day crossing below the 200 day as a sign of waning momentum (or the death cross) but we can save the dramatics.  Quite simply, the stock bounced where it should have, and with today’s rejection a re-test of $135 in the coming days could cause a break to $130.

Short dated options prices have been ticking up a tad, with 30 day at the money implied vol at 18.5% (blue below), but I would add that realized vol (white line) has also picking up alongside, making options prices not as expensive as they may appear in the current environment.

from Bloomberg
from Bloomberg

The next identifiable catalyst is not until July same store sales in early August, and then fiscal Q4 earnings confirmed for Sept 30th.

I want to make a defined risk directional play that Cost is set to re-test $130 on the downside over the next 5 to 6 weeks (note we bought the 125 puts instead of the typical 120’s for the fly. This only cost us .20 extra and protects us in the case of a substantial move below 130 so that our profits don’t trail off and become long delta risk)

Trade: COST ($139) Bought to Open Aug 140/130/125 broken wing Put Butterfly for $2.70

– Bought 1 August 140 put for $4

– Sold 2 Aug 130 puts at .90 ($1.80 total)

– Bought 1 Aug 125 put for .50

Break-even on Aug expiration:

-Losses of up to 2.70 above 137.30 with total loss of 2.70 above 140.

-Gains of up to 7.30 below 137.30 with max gain of 7.30 at 130

Rationale – This trade targets 130 on August expiration and we moved up the lowest put strike by 5 dollars versus a balanced butterfly as it only cost .20 more and establishes more of a bearish position if the stock does in fact approach the mid point more rapidly.