Restoration Hardware (NYSE:RH) reported earnings last night and Wall Street did not like what it saw. RH stock is down 5% this morning. This is the opposite reaction from Lululemon’s (NASDAQ:LULU) earnings event. These were both retail stocks that have been in favor with investors of late. But one down day for RH stock is not the end of its upside. And therein lies the opportunity.
Big dips on earnings are not usually one-day events, meaning there could be more follow-through to selling.
Especially since RH stock has flown high this year, up 68%, coming into its earnings report. This morning’s fall is much smaller than what the options markets had expected. So a small dip this week is normal price action.
The bulls need to retest footing before proceeding higher. This gives the stock a chance to consolidate and establish a base. Otherwise, this steep rise will create frothy levels that are susceptible to large, sustained corrections.
The knee-jerk reaction last night, as soon as the earnings headline broke, was to rally. So there was good news in the report. They did miss on revenue which is concerning, but not game-changing … yet. Management did well to beat their bottom line targets, and that shows competence.
From a valuation perspective, these are not cheap stocks but they are doing things right. RH and LULU are delivering enough growth to justify most of the Wall Street exuberance.
Technically, Restoration Hardware is a momentum stock and those are difficult to trade. On the way up, they perpetually seem like they are ready to correct. And on the way down, they look like they are going into an abyss. That’s why I use options today to slow the action down a bit, so I can catch this falling knife with metal gloves.
By using options, I can go long RH and still leave plenty of room for error just in case investors want to punish the stock a little bit more.
Even after a dip this morning, the stock is still trading above an open gap from its last earnings report. However, I find comfort in the fact that the $130 per share has been a successful defense for the bulls.
It is my contention that 2018 is still set up to be a good year for stocks and RH will continue to do well through it. So with today’s trade, I generate income without any out of pocket expenses. The idea here is to take advantage of what other people fear on being down days.
If my thesis fails then I own RH shares but at a much deeper discount than the current price. In that event, I am comfortable that I will manage out of them with profits over the mid-term.
The Bet: Sell RH Nov $105 put and collect $2 per contract to open. I have a 90% theoretical certainty so that I retain maximum gains. Otherwise, I will accumulate losses below $103.
Selling naked puts carries big risk especially for a momentum stock like RH especially when markets are at all-time highs. For those who want to mitigate it, they can sell a spread instead.
The Alternate Bet: Sell the RH Nov $105/$100 bull put spread. Here my risk is smaller yet the spread would yield 15% on risk. Compare this with risking $141 to buy the shares and leave no room for error.
Click here for more of my market thesis and get an ongoing free copy of my weekly newsletters.
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 as @racernic on twitter and stocktwits.