LULU: Action, Reaction in a Short-Term Correction

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- I love market corrections. The one we're going through now should come as no surprise. Don't believe the headlines that proclaim the sky is falling. I tend to sit closer to the side of CNBC's Larry Kudlow, who says The Economy Isn't Collapsing, Nor Will Stocks. While I am not as bullish on America as Kudlow, I've been around long enough to not overreact to the stock market's natural gyrations.

When the market swoons and stocks tank, investors tend to fall into one of three camps: Panic sell, buy low or do nothing. I often fall into the last two camps. Ultimately, my cash flow at the moment dictates whether I can make considerable buys or if I have to stay on the sidelines. More than three ways exist, however, to react to what amounts to a normal downturn. In fact, I would even advocate for reacting somewhat aggressively during an all-out crash.

Consider Using Options

After Lululemon ( LULU) reported earnings, the stock took a bit of a dive. Over the last week or so, it has showed some signs of recovery, flirting with the 76-to-77 level, only to succumb to both company-specific and macro pressure. I opened a position in LULU after earnings. Right now, I am sitting on unrealized losses.

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Some investors would call me crazy for not having a stop loss on the position. I do use stop losses, particularly on short-term trades based less on the long-term, but more on technicals and near-term up or downside catalysts. But I shy away from them on long-term conviction plays. I bought LULU because I believe it's a well-run company that will continue to grow at a rapid clip. CEO Christine Day has the factors brick-and-mortar retailers absolutely must have to not only remain relevant, but survive:
  • A high-quality exclusive brand not available anywhere else
  • An affluent, very specific target customer willing to pay a premium for quality and social status
  • The ability to control limited inventory by not discounting.
  • This quarter, Day finds herself with an unusually high level of inventory on her hands. Because Lululemon does not discount -- and the company has essentially trained customers to believe product is scarce -- this typical "problem" in retail should turn into higher revenue. When a dime-a-dozen company like Research in Motion ( RIMM) gets stuck with product, it has no choice but to give it away and take a massive charge. Lululemon runs more like Apple ( AAPL), who, operating from a position of strength, dictates the terms of engagement with the consumer.

    Nothing about Lululemon's long-term story has changed. And it should come as no surprise that the stock moves sharply lower than the major indices. It's a hyper-growth, momentum stock; that's what they do. They react to broad mark strength as well as weakness to the relative extreme.

    So what will I do is I bide my time sitting on unrealized losses in LULU. Once I think the dust has settled, I might execute a buy-write options strategy. That means for every 100 shares of LULU I buy, I will write a covered call against the position. With the stock trading at 71.74 late Tuesday, I could pick up the LULU May 75 call and collect $2.20 in premium. As I said, I will wait to put on the trade, if I end up making it, so consider this example for illustration purposes only.

    Due to the $2.20 in premium, I do not start losing money on this trade until LULU trades below $69.54. To the upside, if I get my shares called away at $75, I will have turned a 4.5% profit on the stock leg alone. Factor in the premium collected and that profit increases to 7.6%.

    I expect LULU to rebound. As such, I think there's a pretty good chance I get my shares called away. If not, I continue to write calls -- and collect income -- until they do. Meantime, I still have my original long-term position. By putting on an additional short-term trade, I offset my off-paper losses and keep myself from a panic sell on a stock I want to accumulate for years to come.

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    At the time of publication, the author was long LULU, although positions may change at any time.