Why Google Is About To Break Out To All Time Highs And A Modified Butterfly To Play It

| About: Alphabet Inc. (GOOG)

For long term holders of Google stock there has been very little to cheer these last five years. After an impressive post IPO run up the stock peaked in December of 2007 at $747 a share. Since then it's been a wild ride, with huge rallies and sudden plunges but no net gain for the past five years.

GOOG Chart

GOOG data by YCharts

Recently Google (NASDAQ:GOOG) has come very close to breaking out to all time highs and the question is: "Is this the time to get on board for the imminent break out, or is this just another head fake?" In the past year GOOG has made two strong moves up, and both times management threw cold water on the rally. First, just over a year ago as the stock was gaining traction they announced the 12.5 billion purchase of Motorola Mobility. The reaction of the market was quick sell off. More recently, after the last earnings report, with the stock up significantly after hours to $660, management announced a stock "split" whereby all shareholders who are not named Sergey Brin or Larry Page lose half of their voting rights. The stock promptly plunged to under $600. Despite this legalized theft, the stock price has quickly recovered, and that is where we stand today. So why do I think that this time is different? In a nutshell, it's because of P/E compression. You see, while the stock has gone nowhere for the past five years, the underlying business has been going great guns.

GOOG Earnings Per Share TTM Chart

GOOG Earnings Per Share TTM data by YCharts

As you can see earnings have almost tripled during the past five years. This acts like a coiled spring, ratcheting down the P/E. At some point investors decide that it's cheap, and there is your floor.

GOOG PE Ratio Chart

GOOG PE Ratio data by YCharts

Since 2007 GOOG has gone from a P/E of over 50 to one that is currently just over 20, even after the latest run up in the stock price. Such is the power of growth. And that's why you should not be afraid of buying Google at $700. It's three times the company that it was when it first hit $700 back in 2007. It could always get cheaper, I guess, but look at that P/E chart again: it seems to hit a floor every time it tries to break 20 to the downside. And given that it's still growing at a fair clip that floor under the stock price just keeps getting higher. Despite the $700 price tag, the market is saying that the stock is cheap.

So how to play it? My current favorite GOOG long position is a modified butterfly as follows:

Buy 1 January '14 800 call

Sell 2 January '14 850 call

Buy 1 January '14 890 call

Cost: $5.00 per combo

You will notice that the outside leg is $10 shorter than the inside one. That's because I want to protect myself from the stock blowing past my profit zone. If you use a regular butterfly and GOOG goes to $1000, then you can be quickly left with significant losses. With this position, you get at least $10 which is a 100% return. Not too shabby. And you also have the possibility that the stock will end up somewhere between $805 and $890 for an even greater return - up to a 10 fold return at $850. I rarely hold my butterflies to expiration however, so the play here is to wait for a rally into my profit zone (along with some time decay) to allow me to cash out with a double within the next few months.

Of course this position would only be appropriate for an experienced options investor. If that's not your thing, I expect that buying the common will also be quite profitable in the near / intermediate term.

Any option traders out there with a different way to play GOOG? I would love to hear your ideas. Happy hunting.

Disclosure: I am long GOOG. 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.