On last night’s Fast Money on CNBC, I detailed some unusual options activity in shares of Costco (COST) in front of tomorrow night’s fiscal Q2 earnings report (watch here).
Yesterday when COST was trading $177, making what was then a new all time high, there was an opening buyer of 4,000 of the March 3rd weekly 170 puts which break-even at $169.32, down about 4.3% from the trading level. The options market is implying about a 3% one day post earnings move on Friday, which is a tad rich of the stock’s 2.5% average over the prior 4 quarters.
What was interesting about yesterday’s put purchase was how it was short dated. It is clearly targeting earnings. But also interesting is how far out of the money the choice of strike was. The premium commitment of $272,000 was not insignificant when you consider the options market was only placing about a 16% chance those puts were in the money on Friday’s close. Which leads me to believe they are likely a disaster hedge for a long holder. Also the $170 strike is interesting as it was the breakout level from earlier in the month when the company reported a monster same store sales print, the stock is up 11% since:
It’s been a weird week for retail stocks. There has been sector volatility surrounding the potential for a border adjustment tax, which would be put in place to help fund the president’s proposed tax cuts (there already is a political fight on this among factions of the Republican party). And among individual names, we all saw Target’s (TGT) massive guide down yesterday, with shares declining 12%. And then you had Lowe’s (LOW) beat today, with it’s stock rallying 10%.
I have no idea what COST is going to print. I suspect a beat and raise and stock continues its grind higher, possibly in line with the implied move.
On the downside, a miss and guide down (which would be surprising after the Jan comp) and the stock is easily back at the prior breakout level of $170. That asymmetry means stock replacement strategies and hedges for long holders and defined risk stock alternatives for those new to the name make sense. The key in a market like this, especially in retail names, is defining risk in case of a big hiccup on the event, but participating in more upside in case of a beat and raise.
So What’s The Trade?
Stock Replacement/ Alternative
COST (177.50) Buy the March 177.5/187.5/197.5 Call Fly for 2.50
- Buy 1 March 177.5 call for 2.45
- Sell 2 March 187.5 calls at .50 (1.00 total)
- Buy 1 March 197.5 call for .05
Break-even on March expiration:
Losses of up to 2.50 between 177.50 & 180 and between 195 & 197.50 with max loss of 2.50 below 177.50 and above 197.50
Profits of up to 7.50 between 180 and 195 with max gain of 7.50 at 187.50
Rationale – This defines risk to just 2.50, less than half the implied move and less than the at the money call in the weeklies. If the stock goes higher this does well in line with the implied move and adds a little bit of room above that with its target 187.50. If the stock were to decline in line with the implied move or worse, this is much better than being long stock as the most that can be lost is 2.50. If the stock goes nowhere it could be a loser, but not worthless and can be rotated out of and replaced with either stock or something farther out for those bullish long term.
Or Hedge
vs 100 shares of COST (177.50) Buy the March 3rd (weekly) 175/167.50 put spread for 1.40
- Buy 1 March 3rd 175 put for 1.70
- Sell 1 March 3rd 167.50 puts at .30
Break-even on March 3rd expiration – Hedge vs stock limits losses below 173.60 down to 167.50 where it will have saved 6.10 in potential losses. Hedge ends below 167.50.
Rationale – For those looking to lock in some profits, this hedge costs less than 1% of the underlying and protects to the breakout level at 170 and then some. A hedge like this every quarter would obviously cut into gains, but in a stock that’s already made a run and one you have profits in, especially with retail stocks making big moves, this is the type of smart hedge that allows you to sllep at night with a longer term holding and not have to make panic decisions on big earnings declines. The ideal situation is the stock goes higher by the implied move or more and this 1.40 is lost.