Update – Home Depot (HD) Replacement vs Hedge

by CC March 20, 2017 10:53 am • Trade Updates

In late February we took a look at Home Depot (HD) on a day that Target (TGT) and other retail stores were getting a beat down. HD has avoided the carnage seen on other box/department store stocks as it is more immune to the Amazon effect. We detailed two trade ideas in that post, both for existing long holders, one a hedge against long shares and a stock replacement. With the stock a bit higher I wanted to check in on those ideas to compare. First, let’s look at the stock replacement. Here it was, from Feb 28th:

If I were long, I would consider stock replacement strategies near term, selling all or a portion of my position at $145.25 to buy a call butterfly with realistic upside but defined risk of just 2.50

HD ($145.25) Buy the May 145/ 155 / 165 call butterfly for $2.50
  • Buy to open 1 May 145 call for 4.30
  • Sell to open 2 May 155 calls at 95 cents each (1.90 total)
  • Buy to open 1 May 165 calls for 10 cents

With the stock higher by about $3 this trade is worth about about 3.75. That’s a nice gain of 1.25 but that’s less than half of the current gains in the stock. Obviously, this trade has a lot of time to play… but intrinsically it’s not that different than its mark to market value, so it remains a defined risk stock alternative with the possibility of being worth up to 7.50, but the stock needs to continue to go higher for more gains.

Now let’s compare that to gains in the stock versus losses in a hedge. Here was that trade idea, also from Feb 28th:

HD ($145.25) Buy the April 145/ 140 / 135 Put butterfly for $1
  • Buy to open 1 April 145 put for 3.50
  • Sell to open 2 April 140 puts at 1.60 each (3.20 total)
  • Buy to open 1 April 135 calls for 70 cents

In this case, the long holder has more than $3 gains in the stock, and losses of about .55 in the hedge. Clearly, holding onto the stock and putting on an inexpensive hedge was the better of the two options at this point. However, if the stock had gone substantially lower in the past few weeks we would be saying the opposite. In this case of a low vol environment, and a stock continuing to grind higher, a hedge vs long stock was the better way to capture near term upside in the underlying, while defining risk (with no events on the horizon). This is an interesting back testing exercise and one we’ll continue on RiskReversal in the future.