Hedging Your Bet On Costco
In a recent article (Amazon No Match For Costco), Seeking Alpha contributor Maltzberger argued that Costco (COST) shares have “plenty of room to run”. In light of that, and with Costco scheduled to release its earnings after the close Thursday, we present our system’s take on Costco and look at a couple of ways longs can limit their risk. First, though, a quick comment on Maltzberger’s comparison of Amazon (AMZN) to Costco.
Costco As A Complement To Amazon
The sense one gets from Maltzberger’s assessment is that Costco has something of a moat to defend itself from Amazon. We’ve made a similar point before, for example here:
If you want Kirkland brand mouthwash (DoctoRx noted the success of Costco’s in-house brand) and don’t want to pay a 466% mark-up to a third-party on Amazon (Costco, wisely, doesn’t sell its heavy-but-cheap mouthwash online), you’ve got to go to Costco.
We are somewhat surprised that, as Maltzberger notes, Costco’s online sales account for only 3.5% of its revenue. We certainly prefer to order what we can from Costco online rather than struggling to find parking at our local Costco.
Our Site’s Current Take On Costco
The screen capture below, from Portfolio Armor‘s admin panel, shows our current potential return estimate for Costco over the next several months: about 2.5%. We explain briefly how this is calculated below.
The “Long-Term Return” column shows the average six-month return over the last 10 years, the “Short-Term Return” shows the most recent six-month return, and the “6m Exp Return” shows the mean of the two. The “Adj Exp Return” is our potential return after gauging option sentiment by attempting to hedge the security against a greater-than-9% decline over the next several months with an optimal, or least expensive collar.
In this case, our system was able to find an optimal collar at the 9% decline threshold using the 6m Exp Return figure, so that’s also our site’s potential return.
The other key figure in the screen capture above is the “Net Exp Return,” which is what we call the potential return estimate, net of hedging cost, on our backend. Note that since the hedging cost here is negative, the net potential return is higher: 4.4%. That number is what drives are overall ranking of securities.
As of Wednesday’s close, of the 4,000+ securities with options traded on them in the U.S., 1,997 of them passed our two screens to avoid bad investments. Costco was one of them, but it was ranked 930. Given that 929 names rank higher than it now, Costco is unlikely to appear in one of our Bulletproof Investing portfolios this week.
Adding Downside Protection To Costco
Here we’ll assume you own 1,000 shares of Costco and are bullish on it, but want to limit your downside risk in the event it does poorly or the market goes against you over the next several months. We’ll assume also that you are willing to tolerate a drawdown of 14%, but not larger than that.
Positive Cost, Uncapped Upside
As of Wednesday’s close, these were the optimal, or least expensive, puts to hedge 1,000 shares of COST against a >14% decline by late April.
As you can above, the cost of this put protection was $ 2,870, or 1.74% of position value (calculated conservatively, using the ask price of the puts).
Capped Upside, Negative Cost
We’re going to make one further assumption here: that if you are long Costco, you are more bullish on it than our site is. So, instead of capping this optimal, or least expensive, collar at our potential return estimate of 2.5%, we have capped this at 8%, which was the highest cap we could use while eliminating the positive hedging cost.
As you can see above, the put leg of this collar uses the same strike as the first hedge, so the cost is the same: $ 2,870, or 1.74% of position value. But as you can see below, the income generated by selling the call leg was higher: $ 3,500, or 2.12% of position value (calculated conservatively, using the bid price of the calls).
So the net here was negative, meaning you would have collected $ 630, or 0.38% of position value when opening this hedge, assuming you placed both trades at the worst ends of their respective spreads.
Wrapping Up: Should You Hedge Costco?
Since we’ve got 929 names ranked higher than Costco, we’d suggest you consider holding one of them instead. But if you want to stay long Costco while limiting your downside risk, you should really consider hedging. Remember, stop orders won’t protect you if a stop gaps down below your stop price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.