For the past several months, one trend has been pervasive across the stock market: investors have been trickling into recession-resistant stocks over their riskier competitors.
You can see this trend play out in companies like Procter & Gamble:
…and Dollar Tree:
Obviously, companies like these do fine – or even do better – during economic slumps. People still buy cleaning supplies, personal grooming items and other necessities no matter what the GDP is doing. And if we find ourselves in a really bad economic position, customers will favor discount shopping at stores like the Dollar Tree.
None of this is to say that a recession or deep economic setback is definitely going to happen. But investors have been inching toward protecting themselves.
There’s another company, however, that has been a beneficiary of this risk-off trend: Costco Wholesale Corp (COST):
Costco is a giant warehouse membership discount chain across North America and a few other places around the globe. The appeal is simple: why go out and buy soap, paper towels and all kinds of other items a few times each month at full price when you can buy them in bulk once at a discount?
The thing with Costco is not that it does well in recessions. It doesn’t necessarily. It just does less bad than a lot of other retailers and store chains. Its membership fees cover most of its revenue structure. The discounts, it absorbs and negotiates with suppliers… so people continue to pay their memberships.
But here’s the problem: Costco as a stock has gotten too popular.
That $245 price tag is its all-time high. If we pull back the price range to five years, you can see how its chart looks one sided:
Now, we’re not saying that the company hasn’t grown at a rapid rate to back much of these gains on the investor side. It absolutely has.
From 2015 through last year, revenue jumped 22% and net income grew 32%. Those are incredible numbers for a 12-figure company (with a market cap of $108 billion).
But you can see a slight problem here. While its underlying business has done quite well over this period, its stock has done even better… too well, one could argue. After all, does a 150% stock gain make sense for a 32% earnings increase?
We’re not arguing that anyone should go out and short shares of Costco. But considering investors proved they are willing to take profits at these price levels (as they did during the fourth quarter last year), we might see a slow down for COST shares over the next few weeks.
It shouldn’t be too serious. But a retraction back to below $230 is on the table. Of course, one way to play that short-term price realignment would be to simply buy put options on COST. But with just one extra step, you can do even better…
A Strategy to Play a Short Term Correction
Put options offer a great way to leverage declining share prices without needing to put your portfolio at risk by trading on margin with your broker… as you would by shorting a stock.
But they can be expensive if not offset by some other income. Fortunately, there’s a strategy to do just that – offset risk without greatly decreasing the profit potential of a put.
A bear put spread is a type of trade that involves buying a put option on a stock you believe will fall in price and selling a second put option with a lower strike price.
What this does is offer much of the return potential from the first put while reducing the amount of money to get in by collecting some income from the second one.
You’d still profit as the underlying stock declines in price. But in exchange for the reduction in cost (and amount at risk), the profit potential is capped.
You can see how this trade looks here:
Source: The Options Industry Council
The only time where a straight put option unhedged makes more sense is when you believe a stock is due for a heavy loss. That’s not the case with Costco. The company is still in the right market at the right time, offers substantial growth and economic safety. But it is overbought. So, a decline is in order… but not a crash.
So, a bear put spread is the right move here. Let’s look at a specific example.
A Specific Trade on COST’s Near Term Price Realignment
With a current price of $245 and a target fall to below $230, those are the strikes the make the most sense for this particular trade.
So, a trader looking to get into a bear put spread on COST could buy a May 17 $245 put for $5 per share and sell a May 17 $230 put for $1.08 per share. That results in a net debit of $3.92 per share or $392 total (each option covers 100 shares).
That’s the total amount at risk with this trade. While not a tiny amount, check out the potential return here.
If shares really do fall as far as $230 – which wouldn’t be hard considering they were at $200 at the start of 2019 – the trader would collect a total return of $1,108.
To find that, take the difference in strike prices ($245 – $230 = $15), subtract the cost ($15 – $3.92 = $11.08) and multiply by the number of shares ($11.08 x 100 shares = $1,108).
Think about that; $1,108 would be a 283% return on the $392 at risk. Of course, Costco could defy gravity and remain above $230 per share. But this trade could still turn a profit even so.
To find how far COST has to fall before this trade enters profit territory, simply take the total cost and subtract it from the top strike price ($245 – $3.92 = $241.08). That is a move of just 1.6%.
Considering Costco shares have rallied 22.5% this year so far, a tiny decline like that is more than possible… it’s probable.