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A Crack in the Affluent Consumer Argument

A Crack in the Affluent Consumer Argument

Some analysts argue that recessions have little impact on some stores. Luxury brands, for example, allegedly enjoy customers who tend to spend no matter what the broad economy does. Of course, there are analysts that disagree with this analysis.

The counterargument can be simple. Analysts can point to Tiffany & Co., a company that undoubtedly targets an affluent demographic. In the bear market in 2008, shares of Tiffany lost more than 70%, more than the S&P 500 which lost about 55% over that time.

Watching for Cracks at the Top of the Economy

The failure of affluent customers to boost high end retailers allows investors to focus on companies targeting this group for signs of weakness in the economy. That makes the recent earnings report from Costco Wholesale Corporation (Nasdaq: COST) important to consider.

Millions of consumers pay an annual membership fee to shop at the company’s warehouse stores. They buy in bulk and although per unit prices may be lower, three packs of toothpaste cost more than one even at a 25% discount to the retail price.

Not surprisingly, analysts note that the typical Costco shopper earns about $100,000 a year and is a homeowner. The company understands its customer base and doesn’t try to offer something for everyone. It ignores the demographic that dollar stores focus on and that strategy has generally been successful.

However, the most recent earnings report raised initial concerns for investors. CNBC reported,

“Shares of Costco Wholesale skidded 6.8 percent…after the company reported weaker-than-expected earnings amid increased competition.

The fresh grocery business is getting increasingly more competitive, putting more pressure on Costco’s profit margins as it tries to keep up with rivals like Amazon‘s Whole Foods and Walmart‘s Sam’s Club. Costco’s stock is up 21.7 percent from the year, holding its own against those retail giants, whose market values dwarf the wholesaler’s $99.3 billion.

“There’s been a little bit more retail competitive pressure out there, not only from supermarkets but Sam’s as well,” CFO Richard Galanti said during the quarterly conference call Thursday. “We’ve got good fresh sales numbers, but we — like others — our competitors are working in a little lower margin.”

The company earned $1.61 per share during its first quarter, excluding certain items, missing Refinitiv estimates of $1.62 per share by a penny.

Costco generated better than expected revenue, $35.1 billion, beating Wall Street estimates of $34.8 billion.”

But traders sold the news and the stock broke down from a three month trading range on the report.

COST daily stock chart

The longer term chart confirms the significance of the break. The stock is now showing signs of a significant top formation.

COST weekly stock chart

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread chart

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

A Bear Call Spread in COST

For COST, we could sell a December 21 $205 call for about $3.06 and buy a December 21 $207.50 call for about $1.90. This trade generates a credit of $1.16, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $116. The credit received when the trade is opened, $116 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $134. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($116).

This trade offers a potential return of about 86% of the amount risked for a holding period that is relatively short. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if COST is below $205 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $140 for this trade in COST.

These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.