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Soar Like an Eagle

August 11, 2021

The latest Follow the Flow report is out, and as always there is a play therein that caught my attention.

It's a bullish idea, but I'm going to play this one in a unique way in order to hedge myself a bit in a tape that feels a little sluggish at the moment. I want to get paid to wait out the slow times we're likely to "enjoy" from now until Labor Day weekend, and possibly beyond. So this will involve a calendar spread, but with a twist...

The stock we like is American Eagle Outfitters, $AEO.

Here's what Steve Strazza had to say about it:

American Eagle Outfitters was one of my favorite clothing stores to shop at back in high school. According to the market, I may need to dig through my old dressers as American Eagle jeans are apparently back in style…

Here’s the $AEO chart:

After more than a decade of no progress, the stock resolved higher from a 14-year base this year. Sellers had their chance to knock it back down, but buyers successfully defended the breakout level around 34.

For now, price is consolidating in a tight continuation pattern above this critical zone of former resistance.

Depending on one’s risk tolerance and objectives, we can play this name on the long side in one of two ways. We can own $AEO above the 2007 highs around 34-35 or buy strength above the recent all-time highs of ~38. Either way, the risk/reward is skewed heavily in our favor with a 2-4 month timeframe and target of 52. If we’re below 34, all bets are off and we want nothing to do with this name.

Alright Steve, I might not agree with your fashion sense, but I like your trade idea and I'm happy to get involved here.

Here's the Play:

I'm buying a $AEO Sept/Jan 35 Call Calendar Spread for around a $2.10 debit. This means I'll be short the September 35 calls and long the January 35 calls. And if I did nothing from here on out, the most I could lose in this trade is this debit I paid at trade initiation. And because of the short calls component, this will be a positive theta play. Meaning, if $AEO simply stays in a range around $35, the position will gain value as we approach September expiration.

But I'm going to get a little creative with this trade. The position management will be a bit involved.

First off, the easy stuff: If at any time during our involvement in this trade $AEO sees a close below 32.50 per share -- that's my signal that our bullish thesis is either early or wrong. Either way, we want out and we'll close the entire position down for whatever we can salvage.

Here's where it gets creative: If/when $AEO starts moving higher, I am going to look to roll the short options up a strike and out an expiration (or two or three) for credits. For example, if $AEO trades up to $36, then I'll look to roll my short Sept 35 calls to Sept24(weekly) 36-strike calls for a net credit ("roll" means to buy-to-close the existing short calls and sell-to-open new short calls, all in one trade). Those Sept24 weekly calls are the next expiration series available. If at that time I cannot make this particular roll for a net credit (no matter how small), then I'll look to the next expiration series (same new strike) until I can find one where the roll can be done for a credit. I only want to collect credits for the rolls which reduces my net risk in the trade.

Additionally, if $AEO stalls or retreats a bit and a short call can be covered for 25 cents or less, then I'll close those down and re-establish a new short call position in the next expiration series at the current at-the-money strike (the strike with the most premium).

I'll look to repeat this process of earning credits by rolling the calls to higher strikes at further out expirations until the rolls take us to the January expiration series, which is where our long calls are. When we get there, our position will then have morphed into a vertical (or bull call) spread. At that point, we'll still be long the January 35 calls, but now we might be short the January 40 calls against it (this all depends on the timing of each preceding roll which is unknowable.)

And once we're in this Vertical spread, then we'll hold the position until either the ASC price target of $52 for $AEO shares is hit or we can sell the spread for 80% of its maximum possible value. For example, if we're holding a Jan 35/40 call spread, the most it can be worth is $5.00 at expiration. I'll look to close this for $4.20 which is 80% of $5.00.

I know this is a little bit complicated, so feel free to email me with any questions.

~ @chicagosean

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