For all the talk of recession, you wouldn't know it looking at some retail stocks. Take Canadian athletic apparel giant Lululemon Athletica. Like many stocks right now, LULU stock is extended. It initially broke out in October and has already hit a 20% profit goal. But a bull call spread could take advantage of further momentum, while also limiting risk.
Setting Up A Bull Call Spread On LULU Stock
LULU stock currently sits in the top spot in IBD's Retail Apparel Group, which ranks No. 7 out of 197 industry groups. Lululemon is also a member of IBD's Big Cap 20. It currently boasts a top IBD Composite Rating of 99. Shares have had an impressive run in 2023, up over 56% year-to-date. High growth and the recent inclusion to the S&P 500 in October helped drive gains. But is Lululemon done?
The benefit of a bull call spread is that you get the exposure to the upside potential of a stock move with less capital. To construct a bull call spread, simultaneously buy a call and sell a call at a higher strike price with the same expiration. With LULU stock trading around 507, investors can buy a 510 call while selling a 520 call, both with a Jan. 19 expiration.
To place the trade investors will pay a debit of $4.30 per share. This coincides with a maximum loss of $430 should the 100-share block of LULU stock trade below 510 on expiration. No matter how far below 510 it trades, you won't lose more than the amount paid.
The maximum gain is the width of the strikes minus the debit paid. In this case, a maximum gain of (5 -4.3) x 100 = $570 will be realized if Lululemon trades above 520 on expiration. That's more than a 100% return on risk in less than a month.
Limited Risk On An Extended Stock
For stocks that have displayed strong momentum, but have already run up significantly from their buy points, bull call spreads are particularly attractive. Buying 100 shares of LULU stock would cost over $50,000. Sticking with the long call is significantly cheaper but even that would be a $1,400 cost. By selling the call further out, you bring down the capital at risk significantly. In the event Lululemon shares fall sharply an investor can only lose the debit paid.
That limited risk on LULU stock could be particularly helpful for a high-growth, cyclical stock like Lululemon. While having a three-year EPS growth rate of 39%, even the hint of a hard recession could easily send shares tumbling, especially due to the discretionary, high-ticket nature of Lululemon's apparel.
Nevertheless, by choosing a short expiry on Jan. 19, investors can bet that the market will continue to drift higher over the coming weeks. This could prove fruitful with little economic data or earnings to sour sentiment.
But keep in mind, if LULU stock is wildly successful from here you have limitations on your success. First, the move up has to happen before the Jan. 19 expiration. Second, your participation is limited. Any move above 520 and your profit is capped as opposed to the unlimited profit potential of owning the long call by itself or LULU stock outright.
Please remember that options are risky, and investors can lose 100% of their investment.
