Costco Option Traders Tempering Expectations

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Investors have slightly bid up the share prices of Costco Corporation (COST) after the big-box retail store reported earnings in early December. The earnings report resulted in multiple price target upgrades for the retail stalwart. However, recent overall market volatility has provided choppier waters than Costco stock enjoyed in October and November.

At first glance, it appears option traders are placing their bets that Costco stock can overtake its 52-week high, which it recently set in mid-December. However, a deeper dive into the more granular aspects of the Costco open interest refutes the results of a cursory glance. In addition, aspects of the Costco implied volatility suggest that the market is anticipating more downside in the near term for the stock. 

While the open interest for Costco appears bullish at first glance, a further analysis of recent open interest changes and the impact of implied volatility suggests that option traders are selling call options and buying puts.

Key Takeaways

  • Costco stock remains in a widening upward channel.
  • The open interest appears bullish at first glance but has some glaring bearishness at closer inspection.
  • The share price of Costco has recently pulled back from all-time highs. 
  • Call options remained priced slightly higher than puts.
  • Volatility-based support and resistance levels allow for a larger move to the downside.

Analysis of recent option activity combined with technical analysis of share price movement can help chart watchers gain valuable insight into the overall sentiment toward Costco stock. The chart below depicts the recent price action for the Costco share price as of Tuesday, Dec. 21.

Chart Analysis

This chart depicts the price action of Costco over a period of three months. Each candle represents one trading day. The blue lines are a historical volatility range formed by 20-day Keltner Channel indicators, which depict price levels that represent a multiple of the average true range (ATR) for Costco stock. ATR is a standard tool for illustrating historical volatility over time. Chart watchers should recognize that the volatility bands have been widening since the end of November, when the Costco share price broke its firm upward trend at the extreme high of the range. This implies that confidence in the Costco share price may be wavering.

Starting on the left of the chart, Costco stock traded relatively range bound, as illustrated by the blue channel. Despite crossing over the 20-day moving average several times, the stock never strayed too far from the middle of the volatility range. This also helps to highlight both how strong the extended upward trend was and how pronounced the recent volatility range expansion is.

Costco stock began an upward trend in mid-October, rising to the extreme highs of the volatility range. This trend continued until late November and is illustrated by the green arrow.

At the end of the upward trend, Costco stock briefly fell below its 20-day moving average but has since drifted above this area. The stock appears to remain in a much wider range—however, it’s notable that this wide channel does appear to be trending upwards. During this time, the volatility bands have shown the most expansion.

In the past month, the highest Costco share price was $566.65, in mid-December, highlighted by the green balloon. This also represents the 52-week high for Costco stock. The lowest share price in this time frame was $514.04 in early December, highlighted by the red balloon.

It’s notable that, in this time period, COST reported earnings for the fiscal first quarter. Analysts expected the company to announce $2.67 in earnings per share (EPS) and $49.8 billion in revenue. The company reported $2.56 in EPS to go with $50.36 billion in revenue. Despite missing on EPS expectations, Costco stock rose more than 6% the day after reporting earnings.

Tip

The Keltner Channel indicator displays a set of semi-parallel lines based on a 20-day simple moving average and an upper and lower line. Because the upper lines are drawn by adding a multiple of ATR to the average and the lower lines are drawn by subtracting a multiple of ATR from the average price, then this channel indicator makes for an excellent visualization tool when charting historical volatility.

Option Analysis

Recent trading volumes of Costco favor calls over puts, at first glance. On Tuesday, Dec. 21, 21,000 calls were traded compared to 16,000 puts. While this appears bullish at first, it’s notable that, despite calls having higher volumes trades, puts accounted for a higher notional dollar amount. This could mean that traders are buying higher priced put options as opposed to more speculative, inexpensive calls. However, trading volumes alone only tell one part of the story.

Open interest analysts can provide greater context into the sentiment of option traders. The current open interest for Costco features 122,000 calls against 117,000 puts. This too, appears slightly bullish at first glance. However, further analysis can provide deeper insights into option trader sentiment.

For the Costco open interest, the put/call ratio has risen 5.4% over the past five days. In the same time period, total open interest has fallen by 12%, while call open interest has shed 14% and put open interest has fallen by 10%. This means that fewer traders are willing to place bets on Costco in general, but those that are doing so are placing bets on the downside.

For Jan. 21, the next monthly option expiration date, the single option with the highest open interest is the $550 call, with 3,900. This represents a 0.8% upside in the current share price of Costco stock. The put option with the highest open interest is the $520 put, with 3,100. This represents a 4% downside to current share prices of Costco.

Considering at-the-money options and one strike in either direction up and down the option chain, there are five times more calls than puts in the open interest for Jan. 21 expiration. This is important to consider, as these strikes perhaps reflect more realistic price action based on current share prices rather than far out-of-the-money options, which may have numbers skewed by speculators and option sellers collecting premium.

A key measure for option trader sentiment in open interest is implied volatility. For options expiring Jan. 21, implied volatility suggests that traders are selling calls and buying puts. That’s because for call options, the open interest is rising while implied volatility is falling, suggesting that traders are selling more contracts on short positions in the option. Conversely, for put options, open interest is rising while implied volatility is also rising, indicating that traders are adding to long positions in the option.

While considering implied volatility, it is helpful to understand a concept known as volatility skew. Volatility skew is a measure of market implied volatility to both the upside and the downside, and the comparison of how they relate to each other. Current implied volatility skew is very bearish toward Costco. That’s because the implied volatility for downside puts is greatly increasing relative to upside calls, which suggests that the market is pricing in a larger fear of a downside move for COST. This skew can also be seen visually by the expanding volatility bands on the chart.

The chart below illustrates at-the-money options expiring Jan. 21. The green box represents the pricing that call option sellers are offering, and it implies a 36% probability that Costco shares will close inside this range or higher by expiration. The red box illustrates the pricing for puts, with a 33% chance if prices go lower by expiration.

Macro Factors

Markets have experienced recent prolonged volatility due to several factors. While investors may be fearful of the long-term effects of the omicron variant of COVID-19, the specter of inflation cannot be ignored. According to the most recent consumer price index numbers, inflation accelerated at its fastest pace since 1982 in November.

The mention of planned interest rate hikes have recently roiled markets, as investors look to relative safer havens to park their money. As inflation saps the buying power of the dollar for consumers, investors move their money to sectors that are less speculative and perhaps considered more necessary. This could be considered part of a cycle known as sector rotation. 

The chart below compares the recent performance of Costco stock with Invesco’s Nasdaq-100 ETF (QQQ), State Street’s S&P 500 Index ETF (SPY), and the Consumer Staples Sector ETF (XLP). QQQ and SPY hold the most individual shares of Costco, while for XLP, Costco represents a top-five holding.

This chart helps to highlight how Costco stock has maintained a longer, stronger upward trend than QQQ and SPY. Over the past month, Costco stock has fallen 0.5%, while SPY and QQQ have shed 1% and 2.5%, respectively. XLP, meanwhile, has risen 2.7% in this time period. This could mean that, while investors are rotating into sectors that have historically performed better during times of inflation, they could still see short term downside for Costco stock after it recently reached new highs.

Wrapping Up

While Costco stock has recently broken a strong upward trend, investors and traders appear to have begun to place bearish bets against the company. This is because the option interest suggests that traders are selling calls and buying puts. Even though investors continue to rotate into defensive sectors to better deal with the fallout of inflation, option traders see further downside for the Costco share price from this point.

Source: Investopedia

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