Here’s How to Trade After a One Year Gain of 168%
Many traders tend to focus on finding big gains. They may see a chart of a stock that has made a large move and wish they had been able to trade the stock before the move occurred. This is one way of looking at the markets, but it might not be the most profitable way to look at the markets.
A more profitable approach could be to look at any stock, even ones with large gains, and ask what is likely to happen next. This would involve using strategies other than simply buying shares and taking a long position. Fortunately, a number of relatively simple options strategies are available to traders.
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One of those strategies could be useful after a stock makes a large move like Lululemon Athletica Inc. (Nasdaq: LULU) did. The share price is up 168% in the past twelve months and the stock has been in an uptrend almost that entire time.
An Earnings Report Fuels the Stock to New Highs
LULU announced earnings and according to The Street, the company “posted stronger-than-expected second quarter profits as it ramped up sales in China.”
Lululemon said net income for the three months ending in July rose more than 96% from the same period last year to $95.8 million, or 71 cents a share, handily beating the consensus forecast of $65.8 million. Group revenues rose 25% to $724 million, the company said, and its growth in both online and Asia-based sales should bring full-year earnings into the range of $3.45 to $3.53 per share.
“We all would agree, and when I was looking outside in that, we have a real big opportunity internationally, in particular in Asia, and it’s one that the team feels is a growth potential, just proportionate growth for this business and brand,” said new CEO Calvin McDonald.
“Experiential, how our stores are more experiential than they are today. The loyalty ecosystem, how the guest loves the brand today but how can we build upon that in an even more innovative way.”
Asia sales rose 55% on a comparable basis, Lululemon said, thanks in part to a 200% surge in sales through its new China e-commerce platform.
“In Asia, to start with, we ended the quarter with a 50% combined comp, really seeing strong momentum in both stores and digital, which is good to see and makes us feel good about the momentum we also have going into Q3,” said Lululemon’s Celeste Burgoyne.
“In China, we launched our WeChat store, which we’re really happy with the initial results. And we have an aggressive plan for how digital will lead us into the future in China, specifically.”
Risks Exist in the Stock
While the news was good, there are risks in trading LULU.
TheStreet’s technical expert, Bruce Kamich, flagged the stock’s performance earlier this week in a note for readers of our Real Money platform.
“Lululemon might suffer a short-term shake-out or dip but the overall technical picture suggests we could see higher prices in the weeks and months ahead,” Kamich argued. “The $160 area is our upside price target and longs should risk below $125 for traders and below $119 for investors.”
After the rapid gains, a decline is possible. Traders could manage the risk of a decline with an options strategy.
Trading the Trend
When a stock is expected to move higher, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread that could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for LULU
For LULU, a bull put spread could be opened with the September 21 put options. This trade can be opened by selling the September 21 $160 put option for about $7.10 and buying the September 21 $150 put for about $2.23.
This trade would result in a credit of $4.87, or $487 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $10 ($160 – $150). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $513 ($1000 – $487).
The potential gain is about 95% of the amount of capital risked. This trade will be open for about one week and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool that could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
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.