Amazon Put Option Premiums Are Worth Shorting Here for Income
Amazon (AMZN) made positive free cash flow (FCF) in Q2 when it announced its results on Aug. 3. It could also have another positive quarter in Q3. However, AMZN stock has been weak lately, pushing up its put option premiums. That makes it ideal to sell short out-of-the-money (OTM) put options in order to gain income.
I discussed the company's free cash flow developments in my Aug. 4 Barchart article, “Amazon Stock Soars as It Returns to Positive Free Cash Flow, But It's Still Cheap.” As a result, I showed how AMZN stock could be worth as much as $173.00 per share based on its positive FCF.
That would be a potential gain of 33% over its price today of $130 or so.
FCF Estimates and Price Target
For example, the company said its FCF had an inflow of $7.9 billion over the trailing 12 months (TTM). That worked out to 1.46% of its TTM revenue and I forecast that it could reach 3.0% over the next year or so.
Since analysts now project that sales could rise to $637 billion, this means that its projected FCF could reach $19.11 billion. In fact, Amazon made a 5.26% FCF margin in Q4 2020.
Therefore, on a best-case basis, Amazon could potentially make 5% from $640 billion in sales next year. That puts its estimated FCF at $32 billion.
Using a 2% FCF yield metric means its market cap could eventually rise to $1.6 trillion (i.e., $32 billion/0.02). That is 20% over today's market cap of $1.333 trillion.
In other words, AMZN stock could potentially rise 20% from $130 to $156.00 per share. But remember, this is on a best-case basis.
In the meantime, AMZN stock put options have been rising.
Shorting OTM Puts
This means investors expect the stock to fall further. But we can take advantage of that, at least for expiration periods before the next earnings release. To do this we short out-of-the-money strike prices in a near-term expiration period.
For example, for the Oct. 13 expiration period, which is 18 days from now, the $124 strike price puts trade at a premium of $1.34 per contract. This strike price is 5% below today's price.
That means that the investor who sells short these puts can make 1.08% in income over a less-than 3-week period. AMZN stock would have to fall more than 5% before the investor would be required to buy the stock at $124.00 per share.
Here is what that means. If an investor secures $12,400 in cash and/or margin with the brokerage firm, they can enter an order to “Sell to Open” one put contract at the $124 strike price. Then the account will immediately receive $134 from the short sale of the put contract.
That $134 works out to a yield of 1.08% on the $12,400 invested in the trade. If this play is repeated every 3 weeks, the annualized expected return is 18.36%, since there are 17 periods of 3 weeks in a year.
In other words, the investor could make an expected return (a theoretical return) of $2,278 on the $12,400 invested, if this is repeated at this same price over a year.
Moreover, even if the stock falls to $124.00 and the puts are exercised, the investor gets to keep the $134.00. So, the effective breakeven price is actually $124.00 - $1.34, or $122.66. That is over 5.5% below today's price - giving the investor extra room for profitability.
This shows that there is plenty of upside in AMZN stock, especially if it reports stellar positive FCF.
But even if it doesn't investors can make money shorting puts for income for expiration periods before it reports its Q3 FCF numbers.
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On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.