A CEO Quits and Questions About Why Create a Trading Opportunity
On Monday, the CEO of Lululemon Athletica (Nasdaq: LULU), Laurent Potdevin, resigned after he “fell short” of the company’s standards of conduct. The company noted in a statement that the standards require all employees “to exemplify the highest levels of integrity and respect for one another.”
There were no additional details in the press release or in the company’s filing with the Securities and Exchange Commission.
That filing noted that:
“lululemon entered into a separation agreement and release under which Mr. Potdevin agreed to a general release of claims in favor of lululemon, an extension of his non-solicitation period to a period of 24 months, a covenant not to sue and a covenant of future cooperation.”
The company did pay a price for these terms:
“In exchange for these releases and covenants, lululemon agreed to pay Mr. Potdevin a lump sum cash payment of $3,350,000 as soon as practicable after the effective date of the separation, and a cash payment of $1,650,000 to be paid over a period of 18 months in equal monthly installments beginning 60 days after the separation date.”
For the payment, “Mr. Potdevin…is subject to his continuing compliance with the terms of the separation agreement and release, as well as various other restrictive covenants, including covenants relating to non-competition, non-solicitation, non-disparagement and confidentiality.”
Guidance Balances the News
The company balanced the bad news with some good news. The yoga pants maker said it expects to earn between $1.25 and $1.27 a share, up from a previous range of $1.19 to $1.22, and above the $1.22 guidance.
The company also increased its sales guidance, from $905 million to $915 million, up from a previous $870 million to $885 million, compared to the $883.8 million consensus estimate of analysts.
The company also sought to urge investors to stay focused on the long term, noting, “In addition, the company’s growth strategies remain on track to achieve $4 billion in revenue in 2020.”
At least one analyst is optimistic. According to Barron’s, “Cowen & Co.’s Oliver Chen reiterated an Outperform rating and $78 price target on the stock today, writing that he was encouraged by the company’s ecommerce and brick-and-mortar showing:”
The analyst noted, “LULU’s 4Q guidance raise driven by outperformance in digital and continued strength in the bottoms businesses. Longer-term, we believe omnichannel inventory management strategy, personalized CRM efforts, consistent innovation in pants fabrication, & opportunities for improvement in tops and accessories can drive momentum through FY18.”
Analysts at MKM Partners agreed, noting, “We would view any weakness associated with the announcement of the CEO departure as an opportunity to buy the stock.”
The search for a CEO could take some time. Cowen & Co.’s Oliver Chen estimated a 6 to 12 month search. That indicates the stock could stay in a relatively narrow range while traders are waiting for news.
From the chart, it appears that upside is limited.
The long term chart, which is shown next, shows that the current level of resistance has been in place for years, since 2012.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in LULU
For LULU, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a February 16 $79 call for about $1.50 and buy a February 16 $80 call for about $1.00. This trade generates a credit of $0.50, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $50. The credit received when the trade is opened, $50 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $50. The risk is found by subtracting the difference in the strike prices ($100 or $1 times 100 since each contract covers 100 shares) and then subtracting the premium received ($50).
This trade offers a potential return of about 100% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if LULU is below $79 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 $50 for this trade in LULU.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.