Profiting from Lululemon's pants fiasco

Good trading opportunities aren't always transparent.

By MoneyShow.com Apr 26, 2013 2:22PM

Three adults practicing yoga, focus on young woman with eyes closed, copyright Thomas Northcut, Lifesize, Getty ImagesBy Laurie Itkin, TheOptionsLady


If you practice yoga, no doubt you have heard of Lululemon (LULU). 


At my San Diego health club, many of the ladies parade about in their trendy Lululemon gear. Even though I think the clothes are overpriced, I succumbed to "Lulu-Lust" a few months ago and bought two pairs of shorts and a gym bag.


Imagine my surprise on March 18 when I read the headline, "Lululemon Stock Drops Thanks to See-Through Pants Recall." I logged into my TD Ameritrade account and pulled up a chart of the stock price history for LULU -- and I saw an opportunity to profit on the PR disaster facing the company. 


Let me cut to the chase: I made $695 in just two days by selling put options on LULU. 


I am going to show you how I did it. (Disclaimer: This is not a recommendation to buy or sell LULU stock or options. This article is for educational purposes only.)


I have been trading stocks for 20 years so I have found through experience that when unfortunate things happen to good companies, investors often overreact and unload the stock, which causes the price to drop. In many cases, the stock rebounds somewhat over time. But there are times, however, when a stock will drop and never recover.


One of the options strategies I teach my clients is how to acquire stock at a discount. Being the frugal person I am, I rarely pay full price for clothes. If I see a $100 sweater I want to buy, I wait until it goes on sale. By selling put options, I do the same thing with stock I want to acquire, especially if it is a stock that doesn't pay a quarterly dividend.


As illustrated in the following chart, LULU was trading above $70 per share before the recall news hit, it plunged on March 18, and then opened up around $63 on March 19. On the 19th, I sold five LULUL put options at a $60 strike price set to expire on April 20. In selling these put options (see The MoneyShow's guide), I entered into an obligation to purchase 500 shares of LULU stock at $60 per share on or before April 20. That meant that I needed $30,000 cash in my account ready and waiting to purchase those shares of stock should I be assigned the stock. What did I get in exchange for entering into that deal? I received $1,100 in my account instantly.


What happened next? That day, as I predicted, LULU's stock price began to rise. Not a lot, but in the right direction for my trade. Had the price stayed above $60 for the next month, the option would have expired and I would have kept the entire $1,100. But I'm a fairly conservative trader, so by the time I had made more than half of my maximum potential profit (which took all of two days), I bought my put options back and terminated my obligation to purchase any LULU stock.


chart

Click to Enlarge


As it turns out, my call was right and the stock never dropped as low as $60. In fact, it resumed trading at the previous level of $70 only three weeks after the bad news report. But I don't care that I missed out on another potential $405. A good trader knows when to cap gains and cut losses (see The MoneyShow), and consistency of behavior is key.


Just remember that if you decide to sell one put option on a stock, you must be ready and willing to purchase 100 shares of stock at the price to which you committed, even if you end up over-paying because the stock dropped below that price.


In this case I would have been happy to purchase the shares at $60 if they had been "put" to me. (Remember that I sold five put options, which obligated me to purchase 500 shares of stock at $60 per share.) It would be like the car dealer telling me that a $35,000 BMW would soon be marked down to $30,000 and they would pay me $1,100 to wait to take ownership of the car for perhaps as long as a month at the lower price.


I thought about taking what's left of the $695 profit after taxes and loading up on Lululemon gear. Nah, I'll just wait for another opportunity to buy stock on sale.

Tags: LULU
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