Discount retailer Five Below’s (FIVE) stock was on quite a roll until recently. Between April 4 and June 5, FIVE stock gained 130%, more than doubling from its five-year low of $52.38. 

On March 20, I just happened to discuss Five Below’s unusual options activity, suggesting that the damage done to the company’s stock was overdone. 

“The latest hiccup in its bid for relevance is the tariffs on imported goods from China and elsewhere. I don’t know how much it imports, but it’s got to be a lot to sell at prices of $5 or less,” I wrote. 

“For many, this makes it uninvestable, but yesterday, the stock had three unusually active options, so darn it, I’m devising three ways for aggressive investors to play them.”

The stock was too cheap to ignore, as it traded at 18.2 times its $4.41 per share estimate for 2025, the lowest multiple since its initial public offering (IPO) in July 2012. 

While I liked the value buy for aggressive investors, my bullish strategies suggested calls with too little time and strike prices that were too high. The April 17 $80 and $95 strike prices incurred a loss. 

However, my April 17 $75 long put idea would have paid off handsomely. 

With a delta of -0.29792, you could have sold your put on April 8 for approximately $9.98 [$80.35 share price - April 8 closing price $55.75 * 0.29792 + $2.65 ask price]. That’s a profit of $733, an annualized return of 3,606% [$7.33 profit / $2.65 ask price * 365 / 28].

The reality, however, is that I was bullish about Five Below’s chances, so the long put recommendation was a throwaway for those who took the opposite argument. 

To redeem myself, Five Below’s one unusually active option from yesterday’s trading could be the solution. Here’s why.  

The Option in Question

The July 18 $120 put had volume of 571 yesterday, 5.39 times the open interest. That’s a significant number, given that the 30-day average options volume is just 5,723, and more importantly, the put accounted for 15% of its total volume for the day, at 3,862. 

Working with the July 18 $120 put, I see a covered call and short put strategy unfolding. Here’s how. 

The Covered Call Short Put Strategy

This strategy involves buying the stock, selling a call option, creating a covered call, and selling a put option, thereby creating an additional short put position. 

The objective of this strategy is to generate income from both options, ideally with neither being in the money at expiration. 

I’ve been working on developing a bullish strategy that generates income from both a call and a put for several months. The goal is to create a better entry point for buying the stock while earning a return for waiting for the strategy to play out. 

Ideally, the OTM (out of the money) put’s strike price should be at least 20% below the current share price, and the OTM call should be 50% above the current share price. 

If one can achieve these two conditions within a shorter time frame, all the better, but often the volume just isn't there, so you have to look further out to DTEs (days to expiration) well beyond 60 days.

My strategy is a work in progress. In this instance, I’ve made my life more difficult by working the covered call and short put strategy around the July 18 $120 put that expires in 37 days. 

Working With What’s Available

The first move is to buy 100 shares of Five Below stock. For simplicity's sake, I’ll use the $125.03 closing price. 

Secondly, I need to sell an OTM call, preferably with a strike price 50% higher than the current share price. That would be $185. Unfortunately, you’d be waiting a long time to execute the trade. I’ve got to find a lower strike price with decent volume and open interest.

The July 18 $160 call has an open interest of 89, while the open interest of the $155 call expiring at the same time is 210, providing an upside cushion of 24%. It’s not ideal, but we’ll go with the latter.  

The bid price for the $155 call is showing $0.10, resulting in an annualized return of less than 1%. Also not ideal.

Lastly, you sell a naked put for additional income. The unusually active July 18 $120 put from yesterday has yet to trade early in Thursday’s action. However, the July 18 $125 put has seen one contract trade with a bid price of $6.60, resulting in an annualized return of nearly 54% [$6.60 bid price / $125 strike price].

That’s not half bad. The only problem is that you’re nearly ITM (in the money). With 36 days to expiration, you might be forced to buy 100 shares on July 18. 

The Downside Risk of The Covered Call Short Put Strategy

If you’re bullish, as I am, about Five Below’s long-term potential, it would only be a disaster if the downward momentum of the past week continues. Should the shares fall to $115 over the next five weeks, you’d be looking at a $3.40 a share paper loss [$115 share price - $125 strike + $6.60 net credit].

Which is why this type of strategy is better suited to more risk-tolerant investors. Were the shares to fall to $100 by July 16, you’d be sitting on a $1,840 [$10,000 - $12,500 + $660] paper loss on the put plus an additional unrealized loss of $2,503 on the original 100 shares bought for the covered call. It adds up quickly.

For risk-averse investors, a protective collar —a combination of a covered call and a long put—would be a better option.

Here’s an example.

In this instance, you’ve protected yourself on the downside with the $125 long put, which costs $690, while selling the call, which is covered, providing $225 in income, for a net debit of $465. 

Assuming the same situation from above, where the share price drops to $100, you would be out $465 on the protective collar, plus the unrealized loss of $2,500 from the decline in the value of your 100 shares, but with $1.375 less in losses [$465 - $1,840]. 

The Bottom Line

In the covered call and short put strategy, you would end up with 200 shares of FIVE stock valued at $20,000, $4,343 less than your outlay [100 shares at $125.03 + 100 shares at $125 - $660 on covered call income]. 

In the protective collar strategy, you would end up with 100 shares of FIVE stock valued at $10,000, $2,968 less than your outlay [100 shares at $125.03 + $465]. 

So, if you’re bullish about Five Below, the fall to $100 in my covered call and short put strategy would be a paper loss of 17.8% [$4,343 / $24,343], 510 basis points less than the 22.9% paper loss [$2,968 / $12,968] for the more risk-averse protective collar strategy. It's something to ponder.

Now, I don’t know about you, but my brain is fried from this exercise.

Enjoy the day!