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Costco Shares May Be Getting Ahead of Themselves in Terms of Earnings. A Bearish Trade Using Options

May 15, 2024
minute read

Costco has experienced remarkable growth as a retailer over the past 15 years, but there are concerns it may have overreached. This analysis will review a “broken wing put butterfly” options trade to adopt a bearish stance on Costco.

Costco (COST) has thrived with a business model centered on memberships and low prices, outpacing its peers and achieving a much higher valuation. However, as membership growth slows and margins remain thin, its high valuation poses a significant risk.

In the past year, COST stock surged over 55%, nearly double the S&P 500's return during the same period. Recently, COST hit a new all-time high, but this was accompanied by negative divergence and underperformance relative to the S&P 500, indicating the rally may be losing momentum. The potential for a pullback is increasing, with targets set at $735 in the short term and $700 as an extended target.

Examining the fundamentals reveals a disconnect from reality. COST trades at over 45 times forward earnings, despite profit margins of only 2.5% and an expected EPS growth rate of around 9%, similar to the overall market. With a valuation more than double the average S&P 500 stock, the downside risks are considerable, extending well below the $700 technical support level.

The Trade

Since fundamental valuations take time to adjust, we are starting with a bearish position in COST based on technical chart timing. Additionally, with Costco's high stock price and elevated options premiums ahead of earnings in two weeks, we need a creative approach to structure a bearish trade. We look to the June 7th weekly expiration and propose buying a $700/730/775 broken wing put butterfly for a $9.72 debit. This involves:

  • Buying 1 contract of the June 7th $700 puts at $1.83
  • Selling 2 contracts of the June 7th $730 puts at $4.88 each
  • Buying 1 contract of the June 7th $775 puts at $17.65

While this trade structure may appear complex, it can be simplified into two strategies: essentially, it is like buying a $775/$730 put debit vertical and selling the $730/$700 put credit vertical to help offset the cost.

This strategy risks $972 per contract, or just under 1.5% of Costco’s stock value, while offering a potential profit of $3,528 per contract if COST lands exactly at $730 on expiration day. The trade-off with selling the put credit spread is that if COST falls below $730 at expiration, the profit potential is lower, capped at $528 per contract if COST is below $700 at expiration.

In summary, despite Costco's impressive growth, its high valuation and signs of rally exhaustion suggest a pullback is likely. The proposed broken wing put butterfly trade provides a strategic way to position bearishly, balancing risk and reward effectively.

Bryan Curtis
Eric Ng
John Liu
Editorial Board
Bryan Curtis
Adan Harris
Managing Editor
Cathy Hills
Associate Editor

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