108.3% Potential With This Costco Trade

Investors are looking to build in a bit of safety as we near the end of 2018. Take Procter & Gamble and Johnson & Johnson.

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As you can see, these two consumer staple giants have been on a tear in November and into this month. Why? Investors know that these companies’ customers can’t leave them. They provide the kinds of products that will still be in demand no matter which direction the economy heads, such as Tylenol, Crest, and Band-Aid.

The two questions we should therefore ask are:

  1. Will this continue?
  2. Who else benefits from this kind of movement?

The first is simple. Let’s answer with another question. Do you see the market gaining some kind of firmer footing in the short term?

Of course, markets will remain a bit volatile throughout the rest of the month. We have an upcoming Fed meeting, a political madhouse with the transition of power to Democrats in the House and the usual uncertainty in markets over holiday shopping season.

So, these kinds of plays should continue to outpace the rest of the market until we do find a firmer footing.

The second question, however, is a more interesting one.

Again, let’s start with another question. Where do people buy these kinds of essential recession-proof products?

Stable Staples

This week, the largest grocery store chain in the US, Kroger, posted its third-quarter earnings. The company beat expectations on both its top and bottom lines. Its quarterly earnings per share came in at 11.6% higher than expected. It’s been doing this all year. Yet its stock is only up 2.5% year to date.

While Kroger could be in for a bit of a bump by end the year, there’s another on our radar that looked even more lucrative for the above reasons: Costco Wholesale Corp (NASDAQ:COST).

Costco is the giant in the bulk shopping industry. If you’re unfamiliar with the company, it works like this. It charges a membership to shop at its warehouse stores. With that money, it is able to buy enormous quantities of everything from toothpaste to TVs. It then is able to sell its members these products at sub-market prices.

For a slowed economy, that’s a winning business model. Now, we’re not saying the economy is going to slow… or that the market is on any kind of brink here. It’s just that investors seem to be making moves in that direction for the time being.

This trend, as noted above should continue through the rest of the month. Too many uncertainties are keeping investors away from large purchases of risky investments. They are flooding stocks like Costco.

But the real catalyst for a strong month is the company’s third quarter earnings announcement, set for next week. There’s excellent reason to believe it will be a good one for the company.

Costco is one of the few companies left that gives monthly revenue figures. Along with Kroger’s own earnings, Costco announced a 9.8% growth in November retail sales. That follows the 10.3% growth rate it saw in October.

The company also has a history of earnings beats. And analysts are already expecting EPS to grow 11.7% for the quarter. Anything over that would certainly send shares higher.

However, whenever dealing with a future earnings announcement as the basis for an investment, you should take caution. There’s always the possibility of some unforeseen factor investors won’t like.

So, to sum up the Costco short-term situation, we have:

  1. A stock in an industry set to do well over the next few weeks
  2. A company with strong growth
  3. An impending earnings announcement that could move shares higher
  4. The ever-present risk of earnings disappointment

Fortunately, there’s a strategy to take advantage of short-term strength without taking on too much risk…

A Strategy For Short-Term Strength

A bull call spread is a trade that profits the trader if the shares of the underlying stock rise in value. The risk is limited to the amount that trader puts down to enter the trade. This is called a net debit trade. Here’s how it works.

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Source: The Options Industry Council

As you can see, the potential loss is limited. So too is the potential profit. The reason for using this kind of trade is to profit from an expected short-term price increase without needing to spend a fortune to do so.

To enter a bull call spread, a trader buys a call option then sells another call option with a slightly higher strike price and the same expiration date as the first.

His risk is limited to the difference in the option premiums of the two calls. The sold call’s premium reduces the expense of the bought call.

The trader profits when the price of shares of the underlying stock go higher. The maximum profit potential is reached when shares rise to the higher strike price.

Let’s look at a real bull call trade in COST.

A Specific Trade in COST

If you were to buy a December 21 $225 call for $6.25 per share and sell a December 21 $230 call for $3.85 per share, it would cost $2.40 per share to enter this bull call spread. Since each option is worth 100 shares, that’s a net debit to your account of $240.

That’s the total risk of this trade. Instead of buying shares outright for $225 each and being stuck with them or simply buying the call option for $625, this type of trade limits the total amount at risk to $240.

If shares stay where they are and don’t move to the upside at all, that’s how much you would lose. The same is true if shares fall.

However, if shares rise as could very well happen for all the reasons listed above, you could see a profit.

The maximum profit potential of this trade is found by taking the difference in strike prices ($230 – $225 = $5) and subtracting the cost to enter the trade ($5 – $2.40 = $2.60). Again, since each option represents 100 shares, that’s a total potential profit of $260.

That $260 would be a 108.3% return on the amount of money at risk. There’s virtually no chance shares of COST could move that high on their own. And because this strategy limits the total money needed to enter it versus buying a straight call option, it is far cheaper to get in.

Costco announces its earnings on Thursday next week during the trading session. If any move happens it would happen then. To reach that total $260 per call profit, shares would have to move just $5 or 2.2%. That’s a distinct possibility.

— The Option Specialist

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About the Author: The Option Specialist