Options are a great way for long term investors to dabble in the short term market with limited risk. Like any other vehicle, you have to do your research but it can be a very useful tool and it's fairly easy to understand. Options become even more versatile when you combine two or more "legs" to limit risk or amplify reward.
Before I get into my suggested spread, I want to take a look at Google's (NASDAQ:GOOG) fundamentals and technicals to see how it will perform in the next week. Since its extremely short term, I expect technicals to be more indicative of performance than fundamentals unless we see big news about the company being released within the week.
Google is trading at 642.35 as of market close on Thursday, August 9th. This is just over 15 times forward earnings which is right in line with other tech giants like Microsoft (NASDAQ:MSFT), Yahoo (NASDAQ:YHOO), and Oracle (NYSE:ORCL). It also has a good history of beating market earnings expectations. This coupled with a solid business model and huge amounts of investment in R&D makes for a great long term investment.
Let's take it a step further and value GOOG using the Reverse Discounted Cash Flow (Reverse DCF) valuation method. Reverse DCF looks at the current market price and calculates what kind of growth the market EXPECTS from Google to justify investment capital. A simple Reverse Discounted Cash Flow valuation shows that the market expects GOOG to grow 8% over the next 5 years, which is extremely conservative based on analyst expectations and past performance.
Fundamentals are great when investing long term but I want to point out, once again, that when you're talking about the time frame of a week, fundamentals don't mean much unless there is a huge news event. For this reason, I'm going to give more weight to technicals for this play.
We're going to use the August 18th, 2012 expiry for all the legs of this spread which means we're looking at just 6 trading days for movement.
Above is a six month chart of GOOG overlaid with 7, 14, and 28 day exponential moving averages (EMA). I also chose to plot out the RSI, MACD, and Ultimate oscillator with standard parameters. You can see that the price trades above the 7 day EMA which is well above the 14 day EMA which, in turn, is well above the 28 day EMA. This shows a clear bullish trend. We can look to the MACD to confirm the bullish trend. The MACD signal crossover took place in mid-June and is still above it, though slowing down. This shows that the uptrend is likely going to end in the next few weeks, though it does not seem likely to be in less than 2 weeks.
Looking at the RSI oscillator, it seems we're bouncing off of overbought territory but have a solid uptrend currently. Unless we see a huge rally first, I don't see the marketing moving to correct the overbought signal in the next week. Finally, the Ultimate oscillator shows that we're in uptrend territory but slowing down. Again, it looks as though we will see a trend reversal in several weeks, but not next week.
Based on these simple technicals, I firmly believe we will see GOOG close around $660 by the end of next week. Now for the spread, I will use 2 legs. We will go long 2 contracts for an August 18th call at a strike price of $645 and we will go short for a put at a strike price of $655 with the same expiry.
Should the price approach $660 like I think, we should be able to close out our positions for a total gain of $3500. As long as the price closes out above $647.60, we will have some amount of a profit. On the other hand, should he price dip below this level, we will be able to own shares of Google for $655, which is a great investment for the long term (this is why we look into the fundamentals also to make sure we're okay if we need to own the stock).
Your return on investment depends on what type of margin requirements your broker has for options trades, though you will collect a $350 premium per spread.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GOOG over the next 72 hours.