Don’t Paint LOW With the HD Brush

by Tyler Craig | November 13, 2012 2:45 pm

Don’t Paint LOW With the HD Brush

Home Depot (NYSE:HD[1]) is soaring more than 4% in midday trading on the heels of an impressive Q3 earnings report. The home improvement store generated earnings per share of $0.74 and revenue of $18.1 billion. Investors received the news with much fanfare, driving the stock to yet another multiyear high north of $64.

Not surprisingly, the surge in HD is leading some investors to snatch up shares of Lowe’s (NYSE:LOW[2]) in anticipation of its upcoming earnings report on Nov. 19. LOW rallied as much as 2.8% in the first hour of the trading session before quickly falling back into negative territory.

Before piling into LOW willy-nilly, traders should think twice about whether it’s the best sympathy play for Home Depot’s good fortune — recent history suggests otherwise. And shrewd options players can benefit from mindless pin-action buying ahead of the LOW report.

1113 LOW 300x236 Don't Paint LOW With the HD Brush
Click to Enlarge

LOW and HD exhibit a strong positive correlation. As shown in the chart at right, the correlation study has hovered around +0.75 to +1 throughout most of 2012, which effectively means these stocks have moved in lockstep. Here’s the interesting part, though: The positive correlation has fallen apart on differing reactions to past earnings announcements. So historically, heading into earnings has been the worst time to bet HD and LOW were going to behave in a similar manner.

Yet another data point that should give traders pause is the relative performance of LOW. As shown in the bottom study, LOW has underperformed HD throughout much of 2012. HD is up 52% on the year while LOW is only up 26.6%.

For LOW bears, the options market provides an interesting avenue for playing today’s development in the housing space. Traders who believe today’s pop in LOW is built on a house of cards and the upcoming earnings release is sure to disappoint might consider buying a December 32-30 bear put spread on LOW for $0.70.

With earnings looming on the horizon, implied volatility is somewhat high right now for LOW options, making the purchase of a spread a better alternative to buying put options outright.  The max risk is the initial $0.70 paid and will be incurred if LOW stays above $32 by December expiration.  The max reward is $1.30, which will be captured if LOW falls below $30 by expiration.

Because the strikes selected are out-of-the-money, the suggested spread represents a cheaper, more aggressive bet.

As of this writing Tyler Craig had no positions in any of the aforementioned securities.

Endnotes:
  1. HD: http://markets.financialcontent.com/investplace/quote?Symbol=Hd
  2. LOW: http://markets.financialcontent.com/investplace/quote?Symbol=LOw

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