Morning Update

Last week shares of Lululemon were sold hard after the company reported earnings in-line with expectations but guided lower after announcing a product recall. However this morning on option trader made a large bullish bet that the stock will be higher by January expiration. The trade was the purchase of 3942 62.5/72.5 call spreads for $4.07. The cost of this call spread was then financed by selling an equal number of January 50 puts for 3.52. This brings the net cost of the trade to $0.55, which is the trader’s total risk above 50. If LULU is above 62.5 then the trader gets long exposure to the stock all the way to 72.5. The catch is that the trader would be required to buy the stock at 50 if it is below that strike at expiration.

This spread is conservatively bullish and suggests the trader believes LULU could be oversold after last week’s drop. The big question going forward is how will the recall affect sales? Lululemon expects EPS to drop next quarter as a result of the recall, but RW Baird’s consumer survey suggests that this will just be a small blip in LULU’s impressive run. Baird says that this there will be no lasting consequences of this recall and that the company will emerge from it smarter and stronger. Lululemon’s guidance could be overly cautious and a case of under promising and over delivering. If this scenario plays out, this spread is likely to be a winner. If it doesn’t then this trade has minimal risk down to 50, at which point the trader would be happy to buy LULU for a bargain price and a long term hold.