Using Options To Buy The Pullback In Costco

| About: Costco Wholesale (COST)
This article is now exclusive for PRO subscribers.

During earnings season some stocks will see increased volatility to the upside or downside. This volatility can have an effect on the market, and for investors who are looking for a safer play on the consumer, then focusing on consumer-based companies can be one way to go. In my opinion, Costco (NASDAQ:COST) is a defensive niche stock that is a one-stop-shop for all of a consumer's needs. Rather than go to a separate place to buy groceries, gas, electronics, jewelry or many other items, Costco offers an array of services where consumers can buy at wholesale prices. Costco is a membership warehouse that offers its members a selection of branded and private-labeled brands. Costco buys directly from manufactures and ships the goods to its individual warehouses, which are open seven days a week, within 24 hours.

Costco can be described as a defensive niche play given that it is one of the few companies that charges a membership fee to get into the store. The memberships include Gold and Business at $55 and an Executive membership that costs $110. Members will also receive 2% cash back annually. For those who enjoy making fewer trips to the grocery store and don't mind paying the membership fee, Costco is the way to go. When viewing Costco from an investment point of view here are some reasons why I like it, along with ideas on how to play Costco using options:

  1. In this economic environment in the last couple of years there have been a number of companies that have scaled down. Scaling down includes closing stores, laying off employees, selling properties, or have no plans for future expansion. One example is Best Buy (NYSE:BBY), which has been slowly losing market share. Also, Sears Holdings (NASDAQ:SHLD) sold properties in February 2012, and Supervalu has had to lay off employees. Costco is in a fortunate position where it hasn't been affected by economic turmoil.
  2. Overall, the big box theory is working well for Costco since maintaining a favorable square-foot-to-profit ratio can sometimes be difficult for big box retailers. The companies mentioned above in point No. 1 have had difficulty maintaining a profitable square-foot-to-profit ratio in the past, and more downsizing for Costco's direct/indirect competitors could continue.
  3. A good portion of Costco consumers are families and small businesses, and these two groups make larger dollar purchases than individuals.
  4. Even though a membership may not be suitable for an individual, with the rising cost of food and gas Costco will save individual consumers time and money. If individual consumers are savvy enough to make a bulk of their everyday purchases at Costco, their next membership fee will most likely be free if they have an executive membership.
  5. If Costco's new membership numbers continue to increase, this can help support growing bullishness on Costco.
  6. One of Costco's biggest rivals, Wal-Mart (NYSE:WMT), is getting some negatively publicity. This doesn't mean that Costco is a buy, but negative news for Wal-Mart can be Costco's gain.
  7. Costco is a geographically diversified company and most Costcos are near high-traffic areas and usually in highly populated residential areas. Even though there are more Wal-Marts than Costcos, Costco has to be very selective where to put newer stores since it tends to focus on consumers with a higher income than Wal-Mart. Membership-only stores can be difficult to work in poorer areas of the U.S.
  8. Costco's business model remains intact.

When talking a look at Costco's chart over a period of six months, investors will notice that the $92 level is resistance and Costco has been trending in the lower range of its Bollinger Bands since April 5.

Chart forCostco Wholesale Corporation

If investors want to play Costco using options, I would wait for Costco to get closer to the lower range of its Bollinger Bands and consider buying the 85/87.50 call spread. Investors should give themselves enough time, and I would look at the options that are at a minimum of three months out.

Trade: Buy October 85/87.50 vertical call spread

Buy (1) October 85 call = 5.20 (5.20 x 100 = $520)

Sell (1) October 87.50 call = 3.70 (3.70 x 100 = $370)

Cost: (5.20 - 3.70 = 1.50) (1.50 x 100 = $150 per spread)

Max Profit: (87.50 - 85 = 2.50) 2.50 - 1.50 = 1.00 (1.00 x 100 = 100 max profit per spread)

Days Till Expiration: 180

Note: Investors can look at the same spread for July expiration, but at the time this article was written this is only $5 cheaper than the October spread.

In conclusion, Costco is getting hammered today thanks to the Wal-Mart fiasco. Costco has dropped about 5% since it last flirted with the $90 level in the beginning of April. Costco reports earnings May 24, and I believe investors should use this opportunity to buy on weakness. By using a risk-defined strategy, investors can limit their losses.

Disclosure: I am long COST.