Yesterday, we previewed Lululemon’s fiscal q1 earnings report that came out this morning. We detailed how to define risk into the event, one with a bearish/ hedge downside put butterfly that would ultimately serve its purpose or be a total loss and the other a defined risk long bullish position playing for a breakout.
With LULU stock up and attempting a breakout the bearish trade can either be closed for a loss or held on in case of a sudden reversal. But I want to revisit the defined risk long for educational purposes as it can apply to a lot of stocks in the market that have enjoyed recent runs to new highs, with the potential for a breakout, but where one would be best served to define risk in case of failure.
Here was the bullish defined risk trade:
Stock Alternative / Breakout:
Buy the LULU (67.50) Jun 10th/ July 74/ 67.5 vertical call calendar for 3.00
- Sell 1 June 10th 74 call at .75
- Buy 1 July 67.5 call for 3.75
Rationale – this trade defines risk to just 3.00 (about 4.5% of the underlying). That sounds like a lot but remember the implied move is 10%, or closer to 7 dollars. The trade breaks even on the upside at 70.50, so it is playing for a breakout above recent highs. The weekly call being sold helps finance the at the money calls owned in July. That’s helpful because July vol is likely to get cut by 25-30% after the event. In essence, the call sale in the weeklies covers that vol collapse in July. The strike chosen for the call sale in the weeklies is just outside the implied move to the upside. If the stock outperforms the move to the upside profits are capped above 74, but money can’t be lost because even with the stock substantially higher than 74 the profits of the vertical are 3.50 (max gain before Friday expiration). Assuming the stock is below 74 on Friday, the 74 calls can be rolled to June regular or July regular expiration, further financing the at the money 67.5 long calls in July.
With LULU now above $71, the vertical call calendar is worth about 4.50. That’s a decent return but only about half of the total move. But remember the play was defining risk for a breakout. The real payday would come from a move higher from here, as we’re just barely over the trade’s breakeven.
Looking at each leg of the trade, the July 67.5 calls have seen some premium compression as vol is down from above 40 to below 30. This was expected and that’s where the call sale in the June 10th weekly 72.5 calls come in. We sold those at .75, and despite the stock being higher by $3 those have lost 40c. They’re currently offered at .35 but there’s no hurry to cover as the stock going higher will continue to see the same effect into Friday, with the July calls increasing in value and the June10th weeklies decreasing in value through rapid decay.
So the ideal situation for this position is for the stock to continue higher to 72.5 over the next 2 days. Even if it went nowhere it’d be slightly more profitable as those weekly short call become worthless. At that point (or beforehand) they can be closed and the short strike can be rolled out to July, perhaps with a sale of the July 75’s which are currently about a dollar. That roll would leave you with a very cheap 7.5 dollar wide call spread already well in the money. Again, a great stock alternative for a stock at or near recent highs.