The tech sector, due to how well it has been performing, continues to experience significant inflows. ETFs such as the PowerShares (QQQ) and the ultrapro leveraged version (TQQQ) continue to attract investing dollars en masse. However, core Amazon (NASDAQ:AMZN) investors are staying away from the general ETFs and just remaining long this name in tech. Their reasoning is sound. Just look at Amazon's performance over the past 5 years compared with QQQ and you get an idea of how much this company is outperforming the tech indices in general.
Source: Yahoo Finance
We just need to see the company's growth figures in its latest quarter to see Amazon's peer-leading growth is far from finished. Top line sales hit $51.04 billion which was almost a 43% increase over a rolling quarter basis. Sales jumped by a whopping 31% in 2017 but the first quarter this year outpaced last year's growth. Impressive, to say the least. Top line growth is expected to slow in the next few quarters but analysts are still expecting a 33.5% growth rate which is light years ahead of the 3-year average top-line growth rate of this company.
I like to gauge Amazon by its top-line growth. Bezos has never been interested in a dividend or turning sizable profits for that matter. It has always been about reinvestment which has made a lot of shareholders rich in the process. However, with the share price at almost $1,700 a pop, newcomers wanting to get a piece of the action will need plenty of capital in order to buy a decent basket of shares. Long call options often get a bad rap. However, here is how they can be strategically used in a high-price stock such as Amazon.
We will round up Amazon's current share price to $1,700 for the purposes of the article. So instead of buying 100 shares for $170k, one could buy the January 2020 $1310 call for $51,500 - see below.
Source: Interactive Brokers.com
As we can see in the image, the call option has a delta of 0.832, which means that (all things being equal) the $1,310 call option will move by $0.83 based on a $1 change in the underlying stock. Correspondingly, the delta will increase if Amazon moves up. It will decrease accordingly if the price of Amazon shares moves down.
- So with that type of delta, our call option if we can get some upside movement in AMZN will move almost at parity with the shares. Furthermore, we have only invested $51k as opposed to $170k if the shares were bought outright instead of the option. The clear advantage here with the option is that our downside risk is far less due to putting up less than a third of the capital compared to buying the stock.
- Furthermore (for investors who have no problems buying sizable amounts of stock), the $120k realized saving that was not used (due to the option being bought instead) could be used to gain interest while the option trade plays out. Stock traders (who have the capital to trade either way) many times forget this. Just look at how bond yields, for example, have been increasing over the past while. This option does not expire for the best part of 600 days, which means that any left-over capital can still be put to work in a safer environment. The US 2-year, for example, now yields almost 2.5%. 2.5% of $120k is $3k. If one could pick up interest rates like these, any interest gained can straight away be subtracted from the price of the call option. Now our $1310 call has improved its cost basis and is under $50k. Otherwise that spare capital could be left idle for a strategy that is shown below.
- Leverage though is where call options come into their own. We would need the price of Amazon shares to be at least at $1310+$515 = $1825 at expiration to break even on the trade. Anything above this number would mean that our long call trade would be in profit as the intrinsic value of the option would outweigh what we paid for the option. Here is where we really see the leverage of options. Just say AMZN is at $2000 a share at expiration (January 2020). If we had bought the shares, our rate of return would be 300/1700 = 17.6% or $30k. The option though would have $690 of intrinsic value. We paid $515 for the option. So the rate of return would be 690-515/515 = 34%. So on an investment of $51,500, one would have made $17,500. If Amazon were to surpass $2000 a share, the divergence between the rate of return on the option trade and the stock trade just gets bigger, although the stock trade will always make more profit due to the larger amount having been invested initially. The key here though is that we bought an option deep in the money (which invariably has a high delta). The deeper you go, the closer your break even. This is key.
Now many readers of this article will state that I haven't touched on the downside or the fact that the call option could expire worthless. I discussed in a previous article how one should expect a bullish trend to continue. As the chart illustrates below, the 50-week moving average, for example, has proved strong support for AMZN stock down through the years. If we were to visit those types of levels once more, one could sell the call option for a loss and then buy shares or another option if the moving average got restored. The advantage of this is that if there still was a lot of time value left in the option, one would lose far less dollars from the decline in the price of the option as opposed to owning the shares. Many times options traders have the possibility to buy shares at a lower price even if there were losses on the initial option. As long as strict risk management is adopted, I see no reason not to adopt this strategy
To sum up, long call options get a bad rap sometimes unfavorably. However, as long as the investor buys deep in the money options which have plenty of time, the probability of success of the trade goes up. As always with trades which have a time element associated with them, the best strategy is to have a plan and to start with the end in mind. Patience, persistence and perspiration make an unbeatable combination for success.
Disclosure: I/we 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.