Option Plays in Amazon (AMZN)

AMZN above $130:  that is a lot of books, but there is more to the story.

Amazon (AMZN) is a great company when you consider that they almost invented the online retailing space.  They will be a retailing force for years to come considering how strong their results have been.  The Kindle looks like a hit.  There doesn’t appear to be a large debate over any of these claims.  However, that being said this stock seems priced for perfection.

Here is my concern with this company:  Its P/E ratio is north of 75.  How can a $56 billion company grow enough to justify a multiple more than double that of Google (GOOG) and Apple (AAPL)?

Well, I was going to say they better execute to perfection.  Their margins are not huge, and expectations are high.  Also, there is risk that the Kindle, which seems like its growth engine, gets swamped by the Apple Tablet.  This is still mostly true.  AMZN is really getting the benefit of the doubt on a lot of stuff.  However, as I was writing this, our CTO stopped by for something unrelated, and I asked his opinion.  He loves AMZN, and it has nothing to do with books.  AMZN is way out in front in something called cloud computing.  Rather than buying a bunch of servers and paying to keep them in a data center, an online business can just put its code on AMZNs cloud, and buy CPU capacity by the hour.  There are a couple of reasons this is great, especially for small- to mid-size firms:  First, things like hardware and data centers are both expensive and a front-loaded cost.  Using the cloud lets you pay for what you use, and not spend a ton of money initially to get your site into production.  The other nice complement is that if AMZN is hosting these companies’ servers, they can also pitch to sell their wares when applicable on Amazon.com.    From what I am hearing, Amazon is way out in front in this space, but new competitors could always come in here and take over, potentially.

I think the next six months are really critical for AMZN.  Two things:  As always with retailers, earnings around the holiday season are exceedingly important.  Throw in the fact the last earnings had a huge move, and to say this will be anticipated, is probably an understatement.  Also, AAPL is rumored to be launching its tablet computer.  The Kindle is great, but this type of product is AAPL’s bread and butter.   What if investors see the entrant and get worried about AMZN’s market?  There definitely seems to be room to the down side.

The cloud computing business is going to take a longer time to play out, but it has the potential to open a whole new revenue stream for them.  It makes me less negative on their prospects to grow than I previously was.

From an options perspective, this is déjà vu.  About 10 years ago, people who sold calls in AMZN because it was overvalued were out of money long before the stock broke back down (remember the Blodgett call for $400?).  There is definitely a ton of momentum behind AMZN due to the recent run in the stock from $90.   Based on history, naked shorts should closely monitor the upside moves in the stock, due to the unlimited risk of the option.

For people still bullish on the stock, you might consider a couple of things:  Maybe some upside butterflies out until April since earnings are after January expiration.  Consider limiting the amount of premium that you pay out since the stock has had a huge run.  This works especially well if you have a limited upside target.  Call spreads can work, too, but you most likely will pay out more premium. Buy-writes are another possibility where you take in a little premium.  Since your play is bullish, all of these strategies will lose money in a down move.

For people bearish on AMZN:  you may consider selling call spreads or buying puts, but, currently, the premium is relatively high in the puts.  You will be at risk if the stock rallies.  You can do spreads if you have a target downside price to work around.