Can Amazon keep this pace?

September 21, 2017 12:23 PM

On July 5, 1994, Jeff Bezos founded Inc. It was based in Seattle but its reach was worldwide. It started out as an online bookseller and eventually Amazon drove Borders Books into bankruptcy. It was a short life for Borders, which was portrayed as an evil predator to mom and pop bookstores, but Amazon would grow to become the real Death Star to brick and mortar retail stores. Amazon now sells just about everything online and it is even looking to deliver most of its products via drones.

On May 5, 1997 Amazon (AMZN) went public at $18 per share. A year later it split 2X1, and would split twice more, 3X1 in January 1999 and 2X1 in September of that same year. AMZN stock has not split since and this summer it has breached $1,000. Split adjusted, AMZN’s IPO price was $1.50. If you had invested $10,000 on the IPO date your investment would currently be worth $6,666,666.67 (see “Amazon explosion”).

Jeff Bezos is battling fellow Seattle resident, Bill Gates, for the title of world’s richest person. In 2015 AMZN surpassed Wal-Mart (WMT) as the world’s biggest retailer. The current P/E for WMT is 18.4. The current P/E for AMZN is an astounding 186! If WMT had the same P/E as AMZN, it would be trading at $810. The market obviously believes that AMZN will grow much faster than Walmart, and that it will eventually dwarf Apple (AAPL), which also has a P/E of 18.4. Therein lies the rub. The trend is your friend and the trend is definitely pointing upwards, but the P/E seems ridiculous.

The first thing you need to do when looking at establishing an options position is to look at is the skew. If the demand for out-of-the-money puts is greater than equidistant out-of-the-money calls, then it is positively skewed to the downside and negatively skewed to the upside. That is the way that options on most equities trade. The SPDR S&P 500 exchange- traded fund (SPY) August 240 puts have an implied volatility of 11.28%, and the SPY August 255 calls have an implied volatility of 6.57%. SPY moves down much faster than it moves up, according to the skew. The AMZN September 935 puts have an implied volatility of 22.74% while the September 1065 calls have an implied volatility of 21.74%. It is a normal distribution as opposed to the asymmetric distribution in SPY. Ratio spreads are therefore out of the question.

Here are two options scenarios to play on Amazon. Four weeks before the Sept. 1 weekly expiration AMZN closed at $988.90. The 1010 calls are trading at 12.10 and the 1015 calls are trading at 10.40. Going long five 1010-1015 vertical spreads at 1.70 would cost $850. That would be your max loss at $1,010 or lower on expiration. It currently gives you an equivalent share position of 25 long shares. Your max profit would be $1,650 at 1015 or higher at expiration. The 1020 calls are trading at 9.20. You can reduce your cost by selling the 1020-1015 call vertical at 1.20. You have a max profit of 1.20 ($600) at 1015 or lower and a max loss of 3.80 ($1,900) at 1020 or higher. The max profit, if you combine the two spreads, would be $2,250 at 1015, where the max value for both spreads begins. The most that you could lose would be $250 when AMZN trades below $1,010 or above $1,020 (see “Hitting the middle,” below). Before expiration as AMZN approaches $1,015 the spread would increase in value. It would be a marginal increase, expanding most during expiration week.   

On the downside, you could buy five Sept. 22 weekly 960 puts at 18.10 and sell five Sept. 1 weekly 960 puts at 10.60 for a cost of $3,750. That is your max loss on the trade. The equivalent share position for this spread is short 25 shares. There is no exact profit for a time value spread like there is for a vertical spread. When the short side is expiring, you don’t know what the demand will be for the long side that has three weeks left. Currently the

Sept. 1 put has an implied volatility of 20.76%, while the Sept. 22 put is at 21.40%. The ideal spot at expiration is $960 since your short goes out worthless as your long gains in value as it approaches $960.

When AMZN moves in either direction adjustments should be made. When it moves up you could sell of your long puts and buy a cheaper put nearer to expiration. You could sell put vertical as well. Dynamic hedging gives you the greatest odds of success.

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.