Lululemon stock is showing extremely high implied volatility in the lead-up to its earnings announcement Aug. 29.
There is also significant volatility skew, with short-term options showing much higher implied volatility than long-term options. One way to take advantage of this skew is via a diagonal put spread.
This is similar to last week's example on Nvidia, which has worked well and can already be closed for a roughly 6% gain.
This option strategy is advanced because it utilizes options over different expiration periods and different strike prices.
Let's look at an example:
Traders could sell an Aug. 30 put with a strike price of 235 and buy a Sept. 13 put with a strike price of 225.
Lululemon Stock Trade Setup
As of Wednesday's close, the Aug. 30 put sold for around $3.60 and the Sept. 13 put could be bought for $3.75.
The trade would result in a net debit of around $0.15, which means there is very little risk on the upside. The worst that can happen is the puts expire worthless and the trader loses the $0.15 in premium paid per share.
The risk on the trade is on the downside, with a potential maximum loss of $1,015. This is calculated by taking the difference in the spread of the strikes (10) multiplied by 100 and adding the premium paid (15).
The maximum potential gain is around $800. That would occur if Lululemon stock closes right at 235 on Aug. 30.
The break-even price is estimated at around 220. The trade will do well if Lululemon stock stays above 240 for the next week or so.
Aiming for a return of around 10%-15% makes sense, and I would set a similar stop loss.
The worst-case scenario is a sharp drop in Lululemon stock early in the trade. For this reason, if the stock drops below 240 in the next few days, I would also consider closing the trade early to minimize losses.
Trade About Equal To Owning 3 Shares
The initial trade setup has a delta of three. That means the position is roughly equivalent to owning three shares of Lululemon. Note that this delta number can change significantly as the stock starts to move.
One of the advantages of the trade is that the put we are selling has higher volatility (89%) than the put we are buying (65%). Just like stocks, when it comes to volatility, we want to buy low and sell high.
Closing before the earnings date of Aug. 29 is a good idea to avoid earnings risk.
According to the IBD Stock Checkup, Lululemon stock is ranked No. 18 in its industry group. It has a Composite Rating of 60, an EPS Rating of 95 and a Relative Strength Rating of 11.
It's important to remember that options are risky and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ
