Prior to Lululemon’s fiscal Q3 earnings in early December we previewed the quarter making particular note of how the stock could be a coiled Spring higher on the slightest bit of good news. We and detailed a stock alternative for those looking to define risk but bullish in the stock. Here was the original trade idea and rationale from December 5th:
So What’s the Trade?
LULU certainly looks like a chart that could be bottoming. But the stock has shown massive volatility in the past and defining risk for those looking to play for a breakout from the range is the smart move.
Defined Risk Stock Alternative in lieu of 100 shares of LULU (57.75)
LULU (57.75) Buy the Jan 57.50/67.50/77.50 call fly for 2.50
- Buy 1 Jan 57.5 call for 4.50
- Sell 2 Jan 67.5 calls at 1.10 (2.20 total)
- Buy 1 Jan 77.5 call for .20
Rationale – This trade defines risk to just 2.50. That’s less than half the event risk in the stock itself with a $5.50 implied earnings move either way. On a big move lower this will suffer losses but it’s unlikely to be worthless and is much better than being long stock. On a move higher the ideal situation is for the stock to be at or near 67.5 on Jan expiration. A move higher and not all gains are realized obviously, so patience is a virtue. But it will be a nice winner anywhere above it’s break-even point and vol will come in hard which will help with gains above the break-even
LULU stock flew higher following the report. From Dec 8th:
Regular readers know that we rarely start a trade idea with a technical input, but a securities’ chart often helps inform our thoughts on sentiment, and can be very useful for choosing strikes for options trades. On Tuesday we previewed Lululemon’s (LULU) fiscal Q2 results, and while the stock’s 30% decline from its 52 week highs made in September demonstrate investor displeasure with the company’s fundamentals, the stock’s chart had a sort of coiled spring feel to it.
LULU’s results are out. They were better than expected with a full year guide up, and the stock is up 15% in the pre-market, well above the implied move of 9%
We updated from a management perspective a few days later, on December 12th:
The stock is now higher by more than $10, it was a coiled spring. One issue with defining risk with a call butterfly is that not all the gains are realized immediately, and some patience is in order. So I wanted to go over the stock alternative and see what its profits are now, and how much could additionally could be expected with some patience.
The first thing to look at is the targeted area for the move. The center of the fly is 67.50, and that is the ideal spot on an expiration. Of course LULU gapped even higher than that on a massive move. That’s not terrible, as this trade defined a wide range where profits could happen on the upside. But it also leaves a stock alternative where the stock going down after the big move higher is better.
Right now, with the stock 69.50, the trade is worth about 4.50. Intrinsically it is worth $8 here. That means if the stock just stayed here until January expiration, an additional 3.50 in profits would be realized. Of course that intrinsic value changes with the stock. So if the stock goes higher from here profit potential diminishes, and a move lower towards the mid strike and it increases.
The stock has moved around a bit since the Dec 12th update, but is basically right where it was when we did that update. With the stock 69, the call fly is worth 7.30, so almost all of that extrinsic value has been realized in the form of decay (when a call fly is in the money, it is short premium and gains value each day until expiration as long as the stock doesn’t move or implied vol goes higher).
So for management purposes there’s probably not any great reason to stick around as it’s worth nearly 3 times the original cost if sold here at 7.30.