In a sharp reversal from all time highs made just yesterday, Costco (COST) is down 6% on the day on investor disappointment with an earnings report that showed a continuing fall in comparable store sales and slower than expected membership growth.
Going into the earnings event we thought the stock was at risk of a consolidation or even a sharp pullback and therefore detailed a way to replace or be long stock with defined risk. Here was the trade and rationale:
For those that are long or considering a new long for a breakout we don’t love the idea of doing so without defining risk. Here’s the options trade we prefer to long stock:
Stock Alt/Replacement (in lieu of 100 shares):
COST ($166.60) Buy the January 165/175/185 call fly for 3.00
- Buy 1 January 165 call for 5.30
- sell 2 January 175 calls at 1.20 (2.40 total)
- buy 1 January 185 call for .10
Rationale – This trade defines risk in COST to 3.00 while offering a potential profit of 7.00 on a move to 175 on January expiration. The gains on a move high aren’t immediately realized but implied vol should come in some after the event, helping realize some of the profits. The breakeven on profitability is 168 so just slightly higher than where the stock is trading. Unlike stock, the most that can be lost on a move lower is 3.00.
The stock is down nearly 10. This is exactly the reason a holder with large gains would consider a stock alternatives or replacements into potentially volatile events like earnings. But now what?
If you had long stock going in and replaced it with options, you now have some choices. The first is what to do with the replacement itself.
With the stock at 159 the January fly is worth about 1.35, a 1.65 loss. Compared to the stock, down nearly $10, that’s a huge save and the replacement did exactly what it was supposed to. But now the fly is out of the money and those 165’s don’t have a huge profit potential at just 30 deltas. In fact, the entire fly is just 20 deltas at this point, so it’s a bit of a lotto ticket and no longer acting as a stock replacement.
So if your intention was to reduce risk but stay long COST for the long term it probably make sense to sell the stock replacement and buy the stock back, down 6%.
156.50 is the 50 day moving average and a great spot to do the exchange of options back to stock but that’s a call on what the stock does next, which is tough to tell at this point. So therefore the safest thing to do is sell the call fly now and buy back the stock. That is if you want to stay long COST. For those that aren’t that sure anymore, simply close the call fly and look for a better entry lower.