Costco shares may be getting ahead of themselves into earnings. A bearish trade using options

Costco has had a spectacular run of exponential growth as a retailer over the past 15 years, but has it finally gotten a bit too far ahead of itself? We’ll review a “broken wing put butterfly” options trade to position bearishly on Costco. With a business model focused on memberships and rock-bottom prices, Costco (COST) has grown much faster than its peers and commands a significantly higher valuation. However, as membership growth moderates and margins remaining thin, its astronomical valuation is becoming a significant liability. Over the past year, COST stock has rallied over 55%, nearly double what the S & P 500 returned over the same period. However, COST recently printed a new all-time high earlier this week and this was coupled with negative divergence and underperformance relative to the S & P 500. These are signs that the rally is starting to show signs of exhaustion and is losing momentum. The risk of a pullback from here is higher as a result and target $735 in the short run with $700 as an extended target. If we dive into the business, this is where the fundamentals have stretched quite far from reality. COST trades at over 45 times forward earnings. This is despite profit margins of only 2.5% and expected EPS growth rate that is roughly in line with the rest of the market of 9%. With a valuation that is more than double the average S & P 500 stock, the downside risks are significant, extending well below the technical support of $700. The trade However, since fundamental valuations take time to reprice in the market, we are starting by establishing a bearish position in COST based on the timing of the charts. Additionally, with such a high-priced stock and options premiums elevated with earnings on deck in two weeks, we have to get creative to structure a trade to seek bearish exposure heading into earnings. I’m looking out to the June 7 th weekly expiration and buying a $700/730/775 broken wing put butterfly for $9.72 debit. This entails: Buying 1 Contract of the June 7 th $700 Puts @ $1.83 Selling 2 Contracts of the June 7 th $730 Puts @ $4.88 Buying 1 Contract of the June 7 th $775 Puts @ $17.65 While this trade structure may seem complicated, it can be broken down into 2 simpler strategies. It is effectively the same as buying a $775/$730 put debit vertical and then selling the $730/$700 put credit vertical to help offset the cost of the put debit vertical. It risks only $972 per contract or just shy of 1.5% of the stock’s value, while providing a potential profit of $3,528 per contract if COST lands at exactly $730 on expiration day. The trade off with selling the Put Credit Spread is that if COST declines below $730 at expiration, there will be lower profit potential that is capped at $528 per contract if COST is below $700 at expiration. DISCLOSURES: (No disclosures) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.