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Exuberance is tricky. By definition, exuberance is robustness, or exhibiting the behavior of being exuberant, "joyously unrestrained and enthusiastic". Naturally, we are psychologically intrigued and often attracted to exuberance; whether to an exuberant person who is fun, energetic and full of life, or to an exuberant real estate environment, or to an exuberant stock environment, whereby a company is producing state of the art products/services and its share price seems to move higher and higher due to investors' endless enthusiasm.

Some would argue, and we would agree, that there is nothing wrong with exuberance. It certainly would make a lot more sense to buy a stock enjoying an exuberant environment where others also want to own such stock hence driving prices higher, than to buy a stock that once we had purchased it, we discover that no one wants to own it, and hence we end up chasing prices lower as others are looking to sell it.

On the other hand, what investors do need to avoid is irrational exuberance. Such term was coined by previous Federal Reserve board chairman Alan Greenspan in 1998, and also the subject and title of a book published in 2000 and authored by Yale University Professor Robert Schiller (who may have actually first coined such term). Exuberance is not irrational by definition. However, exuberance can become irrational. Most importantly, in most cases, one can only be certain in hindsight, when it is too late, if exuberance had actually become irrational. As Greenspan stated in 1996:

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

We believe that Tesla Motors, Inc. (NASDAQ:TSLA), Netflix Inc. (NASDAQ:NFLX) and Amazon.com Inc. (NASDAQ:AMZN) are currently enjoying an exuberant environment. Their share prices have appreciated anywhere between 27% and 434% year-to-date, while their price/earning ratios are between 218 and 367 for the year ending December 2013, and between 98 and 113 for the year ending December 2014. Whether such exuberance is irrational or not is yet to be seen. We would not recommend shorting a stock enjoying an exuberant environment, nor would we recommend buying a stock which may later turn out to have enjoyed an irrational exuberant environment.

So how can an investor potentially profit in such environment? In case it turns out that any of these stocks have been the subject of irrational exuberance, then a sharp sell-off would likely ensue, as stated above by Greenspan. On the other hand, if it turns out that such exuberance is not irrational, then the underlying stock would either justify its current value, or possibly grind higher. In either case, an appropriate option strategy may be optimal in order to profit from such uncertainty.

Tesla Motors Inc.

Tesla share price has increased by 434.34% year-to-date from $33.87 on December 31, 2012 to 180.98 on October 4, 2013. Its current market capitalization stands at $21.98 billion. With analysts' earnings estimates of $0.60 for the year ending December 2013 and $1.85 for the year ending December 2014, Tesla's price/earning ratios are 301.63 and 97.83 respectively. With a book value of $5.18 per share, Tesla boasts a price/book ratio of 33.44.

Such valuations are quite high by all measures. Ford Motor Co. (NYSE:F), founded in 1903, currently has a price/book ratio of about $3.48 with a market capitalization of $67.33 billion and one-year forward price/earning ratio of 9.71, while General Motors Corp (NYSE:GM), founded in 1908, has a price/book ratio of 1.77 with market capitalization of $49.41 billion and one-year forward price/earning ratio of 7.81.

There is no question that Tesla, founded in 2003, does not have some of the legacy issues that have haunted Ford and GM, while it is riding the future of the electric car. Nevertheless, it is not a given that a 10-year old company will easily unseat two companies that have been around for over 100 years; if the future of the motor vehicle is to be defined by the electric car, then sooner or later Tesla is assured to face some fierce competition from Ford and GM, as well as numerous other global car manufacturers.

With recent reports that the U.S. is on track to overtake Russia as the world's largest producer of oil and gas combined, and the expected diminishing of U.S. dependence on imported oil and energy products, it can also be argued that the combustion engine cannot be written off yet, especially if such development for the world's largest energy consumer keeps gas prices in check.

Despite lofty valuations for Tesla and potential doubt on whether or not Tesla will lead a shift to electric vehicles, it is not a foregone conclusion that its share price is witnessing irrational exuberance; such conclusion would only be certain in hindsight. However, given the fact that the resulting share price movement would be substantial if Tesla is witnessing irrational exuberance, we would recommend buying puts expiring in March 2014 with a strike of $150, where they closed at a price of about $17 on October 4, 2013, and calls expiring in March 2014 with a strike of $180, where they closed at a price of about $30.48 on October 4, 2013, with a ratio of buying 2 put contracts for every 1 call contract. Break-even would be $244.48 to the upside and $117.76 to the downside.

Hence, if Tesla moves in excess of 35% in either direction, investors would make money. Most importantly, in case Tesla moves to the upside by 35% or less in a short period of time, and in case investors feel that it is a case of irrational exuberance, then investors can sell Tesla shares against the calls, hence creating a synthetic put position with a strike of $180, in addition to holding the existing position of $150 puts, while diminishing the potential option time decay downside of the original option position.

Although investors may be hesitant to adopt an expensive option strategy due to the required 35% move in Tesla shares in order to breakeven, such move could be quite probable given the 434% change in Tesla's shares so far this year. Furthermore, the potential downside risk from an outright long or short position could be substantially higher in case of an unexpected gap higher or lower in Tesla share price.

Amazon.com, Inc.

Amazon share price has increased by 27.17% year-to-date from $250.87 on December 31, 2012 to 319.04 on October 4, 2013. Its current market capitalization stands at $145.76 billion. With analysts' earnings estimates of $0.87 for the year ending December 2013 and $2.82 for the year ending December 2014, Amazon's price/earning ratios are 366.71 and 113.13 respectively. With a book value of $19.11 per share, Amazon boasts a price/book ratio of 16.47.

Some may argue that there is no exuberance in a stock that has appreciated by about 27%, as opposed to others that have appreciated by several hundred percent such as Tesla. We still believe there is exuberance in Amazon due to its excessive price/earning ratios of 366.71 (trailing) and 113.13 (forward) as stated above, its ttm operating margin of only about 1%, as well as its price/book ratio of 16.7, compared to an industry average price/book ratio of about 5.3.

Others would argue that such metrics listed in the previous paragraph are justified given Amazon's 5-year average revenue growth rate of 32.72% . We don't quite subscribe to such argument of sacrificing profitability for revenue growth, with operating margins falling under 1%, for a company that has been in business for almost 20 years since July 1994.

I remember when I was hired in 1996 as head trader for an energy company, with the mandate to grow power and energy trading; while most competitors focused on growing volume of megawatt-hours traded, hence aiming to grow revenues, I concentrated on building our profitability. Ultimately, we became one of the most profitable, if not the most profitable, generating 8 figures annual trading profits, and one of the largest power traders/marketers by default, as those that only targeted revenues faded as they were simply never able to bring in the profitability.

Ultimately, the whole industry collapsed, as the mother of all revenue-growing entities, Enron, collapsed and took down others due to the domino effect of credit defaults and the resulting collapse of power prices. Under no circumstance whatsoever am I drawing analogies between Enron and Amazon, however I am simply stating that one cannot sacrifice profitability for extended periods of time for revenue growth, without an ultimate unexpected event possibly catching up with you, either internally, or imposed by the industry, or by an unexpected competitor, or by disruptive technology, or other ...

As in the case for Tesla, despite lofty valuations for Amazon and potential doubt on whether or not Amazon will be able to sustain an improvement in its profitability and margins, it is not a foregone conclusion that its share price is witnessing irrational exuberance; again, such conclusion would only be certain in hindsight. Given that the resulting share price movement would be substantial if Amazon stock is witnessing irrational exuberance, we would recommend buying puts expiring in April 2014 with a strike of $280, where they closed at a price of about $11.35 on October 4, 2013, and calls expiring in April 2014 with a strike of $320, where they closed at a price of about $24.95 on October 4, 2013, with a ratio of buying 2 put contracts for every 1 call contract. Break-even would be $367.65 to the upside and $256.18 to the downside.

Hence, if Amazon moves in excess of 19.7% to the downside, or 15.2% to the upside, investors would make money. Again, in case Amazon moves to the upside by 15.2% or less in a short period of time, and in case investors feel that it is a case of irrational exuberance, then investors can sell Amazon shares against the calls, hence creating a synthetic put position with a strike of $320, in addition to holding the existing position of $280 puts, while diminishing the potential option time decay downside of the original option position.

Netflix

Netflix share price has increased by 253.45% year-to-date from $92.59 on December 31, 2012 to $327.26 on October 4, 2013. Its current market capitalization stands at $19.28 billion. With analysts' earnings estimates of $1.50 for the year ending December 2013 and $3.33 for the year ending December 2014, Netflix's price/earning ratios are 218.17 and 98.28 respectively. With a book value of $18.76 per share, Amazon boasts a price/book ratio of 17.15.

Exuberance in Netflix shares is evident in its phenomenal year-to-date stock price appreciation, its elevated trailing and forward price/earning ratios, as well as its price/book ratio of 17.15 compared to an industry average price/book ratio of 5.3. It is interesting to note that in the past, Netflix stock price had proven to have experienced irrational exuberance, as it peaked on an intraday basis at $304.79 on July 11, 2011, and within less than 5 months, dropped by a whopping 82.67% to an intraday low of $52.81 on August 3, 2011.

Some would argue that since Netflix shares have recovered all such lost ground, and have even reached new intraday highs of $334.50 on September 30, 2013, that perhaps there was no irrational exuberance in 2011. If that is true, then the irrational exuberance would have actually taken place to the downside... On the other hand, if in the future Netflix shares show another major drop, then Netflix exuberance could have proven to have been 'irrational' not once, but twice to the upside. Again, our objective is not to predict whether exuberance is currently irrational, but to identify exuberance and to potentially profit from an option driven strategy in case current upside exuberance, or future downside exuberance, prove to be irrational.


(Click to enlarge)

Netflix Stock 5-year chart (open-high-low-close) - Source: Yahoo Finance

We had previously written two articles that had provided successful profitable option strategies with no direction bias for Netflix, published on February 22, 2012, "3 scenarios for the Netflix sequel - investors get ready for a 3-D ride", and August 18, 2011, "Will the Netflix drama have a happy ending." Similarly, given recent exuberance in Netflix shares, we would recommend buying puts expiring in March 2014 with a strike of $280, where they closed at a price of about $22.65 on October 4, 2013, and calls expiring in March 2014 with a strike of $330, where they closed at a price of about $41.75 on October 4, 2013, with a ratio of buying 2 put contracts for every 1 call contract. Break-even would be $417.05 to the upside and $236.47 to the downside.

Hence, if Netflix shares move in excess of 27.7% to the downside, or 27.4% to the upside, investors would make money. Again, in case Netflix shares move to the upside by 27.4% or less in a short period of time, and in case investors feel that it is a case of irrational exuberance, then investors can sell Netflix shares against the calls, hence creating a synthetic put position with a strike of $330, in addition to holding the existing position of $280 puts, while diminishing the potential option time decay downside of the original option position.

Conclusion

We believe that shares of Tesla, Netflix and Amazon are currently experiencing an exuberant environment as demonstrated by their excessive valuations of price/earning and price/book ratios, in addition to substantial year-to-date stock price appreciation. Whether such exuberance is irrational or not is yet to be determined, as irrationality is only proven in hindsight. Yet, investors can potentially profit from such exuberance by establishing an option strategy that can potentially break-even from a further move of between 17% and 28% in their share price.

We would establish such strategy with a bias for benefiting substantially from a downside move in case of irrational exuberance, by buying out-of-the-money puts and almost at-the-money calls with a ratio of 2 put contracts for 1 call contract. Naturally, in the case that such shares suddenly freeze and fail to move substantially in either direction during the next 5 to 6 months, or in case investors do not act on a substantial move in either direction that later reverses itself, then investors could experience losses associated with option time decay.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: How To Profit From Tesla, Amazon And Netflix Stock Exuberance