There is do doubt that we are well into the age of Amazon.com, Inc. (NASDAQ:AMZN). The debacle that it caused for traditional retailers isn’t new, and in fact started a decade ago. Most brick-and-retail stocks are but a fraction of what they once were … though there are exceptions, and Ulta Beauty Inc (NASDAQ:ULTA) is one of them.
Yes, ULTA stock is in the midst of a nasty 20% slide in just about two months. And that downturn is about to get worse on Monday, with Oppenheimer downgrading shares to “Market Perform” and dropping its price target to $270 from $330.
However, shares are only down about 5% in the past few months … and up 50% since July 2015. Many experts often refer to it as Amazon-proof thanks in part to its in-store services and best-in-class staff.
When a stock stands out as a winner in a sea of losers, I’m willing to sell downside risk for income against its support levels. Key to this strategy is being willing to own shares at a lower price.
I’m not one to buy and hope for a rally back from this dip, regardless of how deep it is already. So instead of buying shares, I will use options on ULTA stock to set up bullish trades to generate income out of thin air.
The basic strategy: To go bullish on Ulta, I sell puts to someone whose opinion is different from mine. I collect a premium for doing so. If I’m right and the stock stays above my strike price, I win and keep the whole premium as income. In essence, I just sold someone a losing lottery ticket. If ULTA stock falls below the strike price, I must own shares at that price even if Ulta falls far below it. Therefore, opening that trade will require cash margin to secure the risk with the broker.
But there are ways of mitigating such risk. Instead of selling naked puts, I can sell a spread. There, in addition to selling the puts, I buy an equal number of them but lower. This caps my risk and renders the risk of the trade more finite.
Fundamentally, ULTA stock may be expensive relative to retailers like say Macy’s Inc (NYSE:M), but not when compared to relative champs. As the saying goes, you get what you pay for. And in this case — especially after a sizable correction — Ulta Beauty is far from bloated.
Catching a falling knife is daunting to most investors, especially when that falling knife trades for three digits. That’s why I use options. There I can build buffers and make room for error, so I can withstand a few bad days of price action.
Not all falling knives are equal. Consider the long-term charts of ULTA versus long time losers like Macy’s. They are in different leagues. Thus, my trade idea on Ulta Beauty isn’t a bet on retail, but instead an exciting spec play that has been working for years. It’s an opportunity to enter a hot stock.
I am comfortable adding bullish risk under the assumption that markets in general are still bullish and that ULTA will continue to outperform.
Click to Enlarge The $245 per share is the bottom end of a long-term ascending channel, so this is still inside the normal price action of a long term slope. They do go through bad jags which is normal, as long as the business opportunity remains the same as this does.
How to Trade Ulta Stock
The Bet: Sell the Jan 2018 $160 put and collect $3. Here I have a 90% theoretical chance of success. But if the stock price continues to fall, I would accrue losses below $157.
The Alternate Trade: Sell the Jan $270/$265 credit put spread where I have about the same chances of success but with much less maximum risk. If I win, the spread would deliver 18% in yield.
Compare this with trying to catch the falling knife here without any room for error. At least if this trade sours, I would be buying ULTA stock at 34% below current prices.
Investing is not a guarantee of victory, so never risk more than you’re 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.
