Last week saw further deterioration in the consumer discretionary sector. Most notably in the share price of retailer Lululemon Athletica Inc. (TSX: LLL) and T-shirt manufacturer Gildan Activewear Inc. (TSX: GIL). Gildan’s share price dropped 35% as the company projected zero earnings for the first quarter of 2009, following a 20% drop in US shipments last month.

It seems whenever a company announces what should be a predictable downturn in sales, the market immediately assumes bankruptcy as the most likely outcome. But not all companies re as badly managed as the Detroit three automakers.

The real question is whether retailer share prices have declined sufficiently to discount the expected slowdown tied to the recession. Or, conversely, could the holiday season actually be worse than expected?

Certainly, if you believe in the efficiency of the market’s discounting mechanism, there are some interesting covered call writing strategies available with GIL. On the other hand, if you believe the market has only partially discounted the risk, bear call spreads are a better choice.

The covered call trade is based on a long-standing truism, that when stocks fall sharply, there is a spike in the volatility assumption attached to the options on that stock. At the end of last week, for example, options on GIL were trading with implied volatilities of 85%.

Mind you, in the current market environment, 85% implied volatility is hardly noticeable. Especially when 100% + volatility assumptions have become common place. Which is unfortunate because we forget just how much premium 85% implied volatility provides.

If you believe in the survival of consumer discretionary companies, then look at buying GIL at $10.90, and writing the January 11 calls at $1.10, or the April 11 calls at $2.20. Buying GIL and writing the January 11 calls yields 12.2% if exercised. If the April 11 calls are written, the four month return if exercised is 26.4%.

The bear call spreads on the other hand, is a strategy where the maximum return occurs if the stock remains where it is or falls. With GIL, try writing the January 10 calls at $1.60 and buying the GIL January 13 calls at 45 cents. The net credit on this trade is $1.15. If the stock is below $10 at the January expiration, both calls will expire worthless. Your profit is the net credit.

The maximum risk on this trade occurs if the stock is above $13 per share by the January expiration. However, at any price above $13 per share the long call will offset losses in the short call. Maximum risk therefore, is the $3.00 per share difference in strike prices.