Lululemon: Highest Returning Protected Covered Call

May.21.12 | About: Lululemon Athletica (LULU)

A protected covered call or collar search performed using PowerOptions tools, seeking to find the highest returning position for profitable companies with a maximum potential loss of 8% and a stock price in an uptrend and near the lower Bollinger band, produced athletic apparel company lululemon athletica (NASDAQ:LULU) as shown below:

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Following very close behind lululemon were apparel and accessory company Michael Kors (NYSE:KORS) discussed in this article, light emitting diode company Cree Research (NASDAQ:CREE), bio-pharmaceutical Onyx Pharmaceuticals (NASDAQ:ONXX) and bedding products company Tempur Pedic (NYSE:TPX).

A protected covered call may be entered by selling a call option against a purchased or existing stock and using some of the proceeds from selling the call option to purchase a put option for protection or "insurance." The lululemon protected covered call has a potential return of 3.8% (48% annualized) with a maximum potential loss of 7.7%, so even if lululemon's stock price goes to zero, the maximum loss that can be sustained is 7.7% (at expiration).

The highest returning positions as shown above were found by searching and selecting to sort by the highest returning positions. Profitable companies were found by selecting to search for companies with a Price-to-Earnings ratio (P/E) greater than zero. Stock prices for companies in an up trend were found by selecting to include companies with a 100-day moving average greater than the 200-day moving average. Searching for stocks with a stock price near the lower Bollinger band reveals stocks that have pulled back in price and may be basing for the next leg up in price. The 8% maximum loss parameter was selected, as a loss of 8% or less can often be recovered fairly quickly using option income generating investment methods.

Lululemon develops and markets athletic apparel targeted for yoga, running, dancing and other sweaty endeavors. In its Q4 2011 earnings call held on March 22, 2012, the company indicated 37 new stores were added over the course of the last year and comparable sales increased by 20% for the year. The company launched its e-commerce website in April of 2011 and web sales now represent 11% of sales. The company has 150 North American lululemon stores and sees the potential for a total of 350 stores. The company is seeding its presence internationally in London, and Hong Kong. Lululemon is introducing country-specific web pages for Australia, U.K., and Hong Kong.

Competitors to lululemon include Nike (NYSE:NKE) and Under Armour (NYSE:UA).

Lululemon's stock price has more than tripled over the last year three years as shown below:

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Lululemon's stock price has recently pulled back and is well off of its previous support level in the $45 range. With a Price-to-Earnings (P/E) ratio of 52 and a Price-to-Sales (P/S) ratio of 10.9, lululemon's stock is priced to perfection; one whiff of bad news and the stock price will most likely drop to its previous support level of $45. Luckily, the company does not have a large presence in Europe, which is currently facing strong headwinds related to sovereign debt issues.

The company's next earnings release hasn't been announced yet, but should happen sometime in the next few weeks. The potential earnings release is a potential reason lululemon popped up as the highest returning covered call in the list shown above, as the implied volatility related to a company's stock options often increase near an earnings release.

Investors long in lululemon can position themselves for generating a profit, yet remain protected via the protected covered call strategy. The protected covered call for lululemon shown above can be entered by selling the 2012 Jun 67.5 call option for $4.40 and purchasing the 2012 Jun 60 put option for $1.91. A profit/loss graph for one contract of the lululemon protected covered call is shown below:

For a stock price below the $60 strike price of the put option, the price of the protected covered call remains unchanged (at expiration). If the price of the stock increased to around $75, the position can most likely be rolled in order to realize additional potential return.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.