But At What COST?

by riskreversal December 7, 2016 1:28 pm • Trade Ideas

The retail sector is one of the best performing since the early hours of Nov 9th following the surprise election results, with the XRT (the S&P retail etf up nearly 15%, very near 52 week highs.  Prior to the election we detailed a bearish view on the XRT (Retail Detail) which has since been proven wrong. One of the inputs we were using was the price action in shares of Costco (COST) into and out of its October same store sales (that came in below consensus) in early November:

From Bloomberg
COST 2 month chart From Bloomberg

November same store sales also mildly disappointed last week, but investors remain either sanguine or just complacent, as the stock remains range-bound just above $150 for the last couple weeks.  From purely a technical standpoint, $150 is near term support, with intermediate term support near its Nov low of $142, with resistance near $160, the early Sept gap level:

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

But that range could change quickly, Costco (COST) will report fiscal Q1 results tonight after the close. The options market is implying about a 3.3% move tomorrow in either direction, basically inline with the 4 qtr average one day move and rich to the 10 year average of 2%.

Despite the implied move appearing fair relative to prior quarterly movement, short dated options prices (30 day at the money implied volatility at 21%, blue below) has been making a series of lower highs throughout the year into earnings events, and might prove to be expensive, and offer the opportunity to sell premium in this wider volatility environment (VIX 11.50!):

COST 1yr 30day atm implied volatility from Bloomberg
COST 1yr 30day atm implied volatility from Bloomberg

Back in September we had the following to say about the competitive landscape for COST’s membership fees. Those fees, for the time being, are the reason for COST’s premium valuation to the market and its peers, despite printing low single digit eps and sales in the fiscal year just ended:

This morning the Wall Street Journal’s Steven Russolillo said that Costco shares should continue to suffer under the weight of competition from Amazon.com and others, as AMZN’s:

annual revenue is expected to surpass Costco’s for the first time this year. By comparison, Amazon had less than half of Costco’s annual revenue six years ago.

Costco’s competitive edge lies in limited product selection, loyal customers and fee income. Its roughly 81 million card holders spent around $2.5 billion in membership fees in fiscal 2015, comprising the bulk of Costco’s $3.6 billion in operating income.

While Costco is still attracting new members, growth in fee revenue decelerated to 4.3% in fiscal 2015, the least since 2009, as exchange rates weighed and past fee-increases faded.

Make no mistake, that deceleration is a result of Amazon’s success with Prime shipping, per Business Insider:

According to a note published by Cowen & Co. on Monday, the percentage of US households that only pay for Prime membership has more than doubled over the past four years, from 7.1% in 2013 to 16.2% in 2016. In the same time span, housholds that only use either Costco (from 14.9% to 9.8%) and Sam’s Club (from 16.9% to 9.7%) dropped noticeably.

In the meantime, households that pay for both Prime and Costco memberships jumped from 4.8% to 11.3% in the past four years, while the same trend is seen among households subscribing to both Prime and Sam’s Club (from 4.8% to 8.5% in 2016).


This chart is a looming disaster for COST, as Prime will continue to grow, likely at the expense of COST:


Not much has changed on this front, and I suspect AMZN’s announcement with their GO Grocery store concept will only intensify competitive comparisons as Food is an increasingly important component for COST.  

So What’s the Trade?

$150 and $155 are the important levels to watch. A move below 150 and there’s only minor support below and no strong support until 142. Above 155 160 looks like resistance. That can help inform strikes for those either long the stock or looking for alternatives to buying the stock here:

Over-write for long stock holders

vs 100 shares of existing COST ($152) stock, sell the Dec30th 160 calls at .70

Rationale – this is a fairly safe call sale against stock. Vol is heightened into the event and the 160 level is resistance. This call expires at the end of the year so it should also benefit from the holiday vol crush assuming the stock is below 160. The only “risk” is being called away in the stock above 160, but that’s after $8 gains in the stock and the short call can be adjusted if the stock is up or at that 160 level.


Stock Alternative

COST ($152) Sell 1 Dec30th 143 put vs Buying 1 Dec 30th 152.5/160 call spread for $1.60
  • Sell 1 Dec30th 143 Put at .75
  • Buy 1 Dec30th 152.5 call for 3.00
  • Sell 1 Dec30th 160 call at .65

Rationale – This long premium trade targets a move to near term resistance and above with a willingness to be put the stock much lower near support. If the stock goes higher and finds resistance at the 200 day moving average (154.50) it is profitable as its breakeven is 154.10. But above that is where the trade shines as it can be worth up to 7.50 at or above 160 to close the year. That’s a good place to target for bulls. If the stock goes nowhere, or down in line with the implied move, all 1.60 can be lost by year end, but that is significantly less than the 5.50+ that is implied for the event move itself. If the stock cannot find support below at the short put strike of 143, you would be long the stock there (and below) so you must be willing to buy stock lower.



vs 100 shares of COST (152) buy the Dec 148/140 put spread for 1.05 cents
  • Buy 1 Dec 148 put for 1.25
  • Sell 1 Dec 140 put at .20

Rationale – Spending a dollar to have disaster protection with up to 6.90 in protection for the event. No protection below 140.