Costco Wholesale Corporation (NASDAQ:COST) has suffered a massive two-day drop that mathematically constitutes an official correction. Since Friday, Costco stock has fallen from $182 per share to $163.
Click to Enlarge A perfect storm of headlines — led by the Amazon.com, Inc. (NASDAQ:AMZN) purchase of Whole Foods Market, Inc. (NASDAQ:WFM) — is the culprit. Though Kroger Co (NYSE:KR) guiding profits down a day beforehand didn’t help things any.
The news that Amazon will suddenly have a 400-plus-store brick-and-mortar presence rang the bell that foretold the death of all food retailers, or so the story goes. Kroger fell more than 10% in one day — a day after plunging 18%. Wal-Mart Stores Inc (NYSE:WMT) and Costco stock also got caught up in the tidal wave, falling by more than 6% each.
But will these stores really die because Amazon owns Whole Foods? No.
Until now, Costco has remained Amazon-proof. There might be an adjustment period for COST following this recent shake-up in the space, but management is up to the task. Expect Costco to avoid being Amazon’d, like what happened to Macy’s Inc (NYSE:M), Target Corporation (NYSE:TGT) and others.
The main difference is that WMT and COST already know how to profit on thin margins. AMZN may even be better than both, but it hardly will be the death toll to these two giant retailers.
Also, while Costco stock isn’t cheap from a price-to-earnings perspective despite the drop, this company does represent some of the best of retail.
Thus, to me, large dips in COST stock are opportunities. However, I’m not reckless, so I don’t plan on buying shares at face value. The drop was massive and deserves respect. I want room for error, as I might not be catching the bottom perfectly, so I’ll use options where I can better control my odds of success.
I am a big fan of Costco stores and Costco stock. I think the company is a merchandising master. I don’t usually succumb to impulse buys, but I’ve fallen for many of theirs. I remember once buying a drum set on my way to buy some lettuce and milk (true story).
So while fear is rampant, I want to sell downside risk. We just need to find support levels that are likely to hold up (and if they don’t, I still need to be willing and able to own shares there).
Wall Street usually overshoots in both directions. If the highs and the lows were overshoots, the truth lies somewhere in the middle. And right now, we’re in the middle of Costco’s 52-week range.
We don’t need to catch the very bottom here; we just need to be close enough to make this setup work.
How to Trade Costco Stock
The trade: If COST falls another 15% by October, I want to own it. Sell the Oct $140 put for $1.10 now, and if the price stays above my strike, we keep our profits and stay out of the stock. Theoretical odds of success are 90%. But if shares fall below $140, then we’ll own the shares and would suffer losses below $138.90.
With a 15% buffer, I am confident that I will be able to manage my risk against shorter-term price gyrations. Still, selling naked puts is not suited for all investors, so I could moderate the risk profile by using spreads instead.
The alternate: Sell the $143/$140 credit put spread, where we have about the same theoretical chance of success, but with limited risk. Still, this spread will yield 10%.
Note that in either case, we don’t need a rally to win out. All we need to profit is for Costco stock to stay above the sold risk.
Selling options is risky business, so never risk more than you are willing to lose.
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.
