Anatomy of the Trade: lululemon athletica Earnings Trade using Options

• Posted by Greg Harmon
• on June 14th, 2011

As lululemon athletica approached their earnings release on the morning of June 10 the stock had been falling and then bounced. It seemed ripe for an earnings play.

The Set Up and Entry:

Below is the daily chart for lululemon athletica (ticker: $LULU) up to 2pm Thursday June 9, the day before they reported earnings. What is prominent is the pullback from the highs appears to have found support at the February high and bouncing.

The technicals (RSI, MACD) supported a move higher with resistance at about 91.80. But the weekly chart below presented a different picture. The down trend continued and the weekly technicals were getting worse. Divergence in the timeframes. With one week to go the June

Options were the vehicle. I’m was looking for the divergence above to create a bit of ebb and flow for a few days, a range per se. With this the trade idea is:

Sell June 85/82.5 Strike Strangles

This is selling the June 85 Strike call and the June 82.5 Strike put. As I reviewed this the Strangles were in the mid $6 range. For the Strangle to pay off LULU needed to close between 76 and 91.50 by expiration, or no more than $6 from each strike. Maximum earnings of the full $6 premium would happen if it closed between 82.5 and 85. But the impending earnings event has also raised implied volatility to over 76% compared to the historical volatility of 39% and the implied volatility for the July options in the low 50s. This meant the options prices were expensive and told me to expect a volatility meltdown in the June options after earnings were announced. This would give an opportunity to profit sooner, provided that the price reaction to earnings was not too extreme. I sold the Strangles at $6.45 right then (the link to the full original trade idea below).

Exit and Risk Management:

LULU posted earnings Friday morning beating expectations and guiding higher. The stock gapped higher over 89 and went as high as 93. Shortly after the open I bought back the short puts at 33 cents and set off to manage the short calls. The price action looked like LULU would fade as anticipated so I set a stop loss on the calls at 7.00 and waited for Monday, time decay was on my side. On Monday the stock popped early and then started to fade lower again pulling the calls lower. As they passed through 4.50 I bought back 1/3 of the calls to bring in some profits. As they kept falling I then bought back another 1/3 when it passed through 3.50 getting filled at 3.38. I set a stop for the rest of the day at 4.50 and a limit to buy at 2.50 for the remaining 1/3, and that is how the day closed. Tuesday LULU looked to gap higher with the broad market and the calls were set to open above my stop. Believing that LULU and the market might fade again after the first 30 minutes I moved my stop to near break even at 6.00 to let the fade happen. It did not and I ended up getting stopped out at 5.99 on the final third. Average cost for all the buy backs ended up being $4.95 for a profit of $1.50 on the trade.

The Takeaway:

The Divergence combined with the elevated implied volatility was the key to entering this trade. After the initial move covering the puts was critical risk management to allow a focus on the position that looked to have potential to move against me. Taking profits along the way is important. If I had not, this trade would be a loser as I write this just 2 hours after taking home $1.50 for 2 and 1/2 days market exposure. Finally setting the stop loss on the final piece to keep from losing any money is of utmost importance. You can always wonder about whether you should have done other things differently but never let a winner turn into a loser. Trade’m well.

lululemon athletica Earnings Trade using Options

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