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I use Amazon (NASDAQ:AMZN) all the time so of course I would think about it as a potential investment. I am sure many of you feel the same way. You may not decide to buy it now, but back after the dotcom bubble burst you could have gotten it for less than $10. Perhaps Amazon was not as much of a presence in our lives back then, but I still used it a lot.

I like how Amazon is always looking into new business opportunities. It made the move into tablets at the right time, and in my opinion it is moving into streaming at the right time too. It is not often the first into a new market, but after it surveys the landscape it jumps in and provides something people actually use. That is a great way to do business. However, the market has been a bit overzealous in judging Amazon's growth. Normally, I would fundamental analyze a company like Amazon till my fingers got tired, but it is just so expensive both absolutely and relatively. Instead I will focus on some valuation metrics, and short term trade strategy. The strategy will be like a prayer that all of us can one day enjoy a cheaper entry, except hopefully it pays.

The Numbers

The price-to-equity ratio on Amazon is scary. It sits at 317.20 according to ycharts. It seems that most of the recent gains have been due to the P/E. Look at the chart:

AMZN PE Ratio Chart

AMZN PE Ratio data by YCharts

Amazon might be doing a good job, but I do not think it deserves a multiple that high. Amazon reinvests in itself. The reason its P/E is so high is because it makes lots of capital expenditures. Amazon does not have a problem generating cash. In fact, one could argue that it does not have a problem at all. I would love to be long Amazon, but I cannot justify to myself buying a stock that looks so overvalued. I think Amazon would need one quarter where revenue growth was slow, or a particular business unit slumped. It might take two quarters to overcome the general exuberance. Will it kill Amazon? No, but the question to ask is whether Amazon would need to implode for a portfolio to be hurt. Imagine if Amazon declined to a P/E of 250, without corresponding earnings growth. That would mean the market assigned it a lower value for the same or lower earnings.

Amazon does not need to collapse and it does not need to weaken. All it has to do is deflate. That is the risk for me here, and that is why I would be remiss to go long. I would not go short either as that incurs too much risk, but I would go for some puts. I will discuss that later.

One other thing I would look at to hammer the inflated price theme in would be the price-to-book ratio. It currently sits at 15.42. It is not the highest it has ever been in the last 5 years, and it is less than double the lowest. I am not so much interested in the absolute number. Amazon has a higher P/B than Apple (NASDAQ:AAPL), which is at 5.694. Still this comparison is not entirely useful. It gives a good perspective though. The trend of the P/B is more important.

AMZN Price / Book Value Chart

AMZN Price / Book Value data by YCharts

Maybe I am interpreting this wrong, but considering how much money Amazon brings in and how small its profits are I would expect their price to book value to fall or at least be flatter than it is. The chart above is the 5 year chart. The 1 year chart shows a much steeper increase, but I did not want to skew the perception. The P/B ratio is not as nuts as the P/E ratio, but it is just going the wrong way. Amazon shrinks profits to increase capital expenditures. The cash should move to the balance sheet, which means the P/E goes up and P/B goes down or stays flat. This is not the biggest factor in my analysis just something that makes me more comfortable.

Amazon Seeks to Expand its Business

Amazon likes to keep its options open. I get surprised at how many things it has decided to break into. Streaming was news to me. I guess I lapsed in keeping up with the universe. A little left behind in the Kindle party too, because they are coming out with lots of different varieties. It was on Amazon's front page, though that link might not permanently work as they keep doing more crazy stuff. I am a fan of the original Kindle. The Fire is nice if you're not much of a reader, but LCDs always hurt my eyes. I prefer e-ink. Luckily, Amazon does both.

A few days after I learned about Amazon's foray into streaming and original content, it made its deal with Epix. Poor Netflix (NASDAQ:NFLX) is going to have a hard go of it. I will look into that company later. I am also a loyal customer there. Hope they don't fold; I get so nostalgic. The point is Amazon has an amazing core business, and is actively exploring new opportunities. That is why I would not go short. Streaming, tablets, and online retail are businesses that are growing. I do not want to be on the short side of those businesses. I will be on the put side though

Trade Idea

Not playing puts close to the current price. I do not want to be hemorrhaging money waiting for a downturn that might never happen. Instead I am looking for Amazon to collapse a little. Imagine Netflix's great fall but to a lesser extent. Netflix was not a terrible business, but they just stumbled and were punished for it.

I had a bit of trouble finding a strike price I would be comfortable with the puts. I am aiming for January 2013 puts. The strike eluded me because they were just too expensive for what I perceive as a long shot. I will be going for the $190 to $200 range on the puts, but I will wait for a rally to eat premiums and time decay. Look at this chart to see why I would choose $200:

AMZN Chart

AMZN data by YCharts

That sheer rise in June 2012 is why I would use $200, because the price went from below $200 to past it in no time at all.

I think we still have some more green times ahead, but the future is not so rosy. Hence trying to get long dated and cheap puts. I am looking for that one big scare that deflates Amazon's price to make it more sane. Right now they are at the $2.90 - $3.85 range per contract. I would wait for it to fall near the $2 range before opening a position.

September might still bring some stormy seas to the market so it could start drifting a bit lower right away. I would grab the $325 January 2013 calls when they hit $1.50 for good measure. I think a fall rally is possible, but around January you start hearing about the fiscal cliff and all the other issues facing the country. The January puts might expire too early. Consider the April 2013 puts, but stick with the January calls.

Do not get wedded to any one strike or expiration date. Scan around for a good place to take a position. I recommend charting the dates for all catalysts for the overall market and Amazon. Then analyze how you think they will go, i.e. green or red, then choose your call expiry date in a way that maximizes positive catalysts giving extra weight to ones nearer to expiry. Conversely, do the same with puts trying to capture all the red catalysts hoping to capture most of them close to expiry. You should have a good idea of when to open a position, and what expiry to use. Strike prices will have to be decisions made at the point of purchase. Do not pay through the nose for premiums.

I won't incorporate that exercise into this post, because the real benefit comes when you do it yourself. Trading options are very much about instincts in my experience. I do best on ones I pick and I feel good about, rather than borrowing an idea from another. I can grab the seed of an idea, but the leg work is mine.

So to summarize I will be looking at the January 2013 calls and puts, and possible the April 2013 puts instead of calls. This all depends on if I see the market or Amazon sputtering. I am looking for a quick downward drop, then I take the profits from my puts. The calls are just to benefit from the potential fall rally, and I would be paying a pittance for those, relatively speaking.

Source: Amazon Is A Great But Fantastically Expensive Company

Additional disclosure: Options are extremely risky. Understand the risk/rewards before doing anything, and do your own due diligence. Not a registered investment adviser.