Expected Returns Investing In Amazon Are Not High – Shorting AMZN Puts Is a Better Play

Amazon Inc (AMZN) stock has been rising despite meager FCF results and heavy capex plans. Investors should be careful. The expected return of investing in AMZN stock, based on analysts’ price targets, is not that high, as this article will show. Instead, value buyers are more attracted to shorting near-term AMZN puts.

AMZN closed at $272.05, up over 1.41% on Monday, and +3.4% higher than April 29 ($263.04), before its Q1 earnings were released after the market closed.

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But this is somewhat baffling, since Amazon reported minimal free cash flow (FCF) and a 95% increase in capex over the last year. Moreover, there is every indication that this free cash flow will languish over the next several years.

What AMZN Could Be Worth

I discussed this in a Sunday, May 3, Barchart article, “Amazon’s Massive Capex Spending Reduces FCF to a Trickle – But Does the Market Care?” I showed how AMZN is worth no more than $265 per share.

I used reasonable expectations for operating cash flow, capex, and free cash flow for the next three years. AMZN stock is basically not worth today’s price; its real value is 2.6% lower.

However, analysts are more sanguine. Their price targets now average about $311 per share. For example, Yahoo! Finance’s analyst survey shows an average price target (PT) of $307.60, Barchart’s survey is $310.09, and AnaChart’s survey shows an average analyst PT of $315.30.

The problem is that this $311 price target average is just +14.3% higher, and could take up to a year, based on how analysts typically calculate their price targets.

The reality is that AMZN stock is at a 6-month peak, and it could easily drop 10% to $244.85 over the next month. For example, look at the huge amount of AMZN put options trading recently. I wrote about that in a May 4 Barchart article, “Huge, Unusual Volume of Amazon Options Trade Today – As AMZN Moves Up.”

At the end of my May 3 article, I discussed expected return and setting options plays. For example, one way to handle this conflict on AMZN’s value is to use probability analysis and set an expected return (ER).

Then an investor can decide on various option plays to maximize this ER. Let’s look at how this process works.

Setting an Expected Return in AMZN Stock

A rational analyst would set an equal chance (33.33%) of (1) AMZN rising 14.3% to $311, (2) staying level at 272.05 (even though I think it’s only worth $265), or (3) dropping 10% to $244.85.

However, just to be generous, and not conservative, let’s give the upside potential a 50% probability and the other two 25% chances each:

$311.00 x 0.50 = $155.50  (i.e., +14.3% upside)

$272.or x 0.25 = $ 68.01    (i.e., flat scenario)

$244.85 x 0.25 = $ 61.21  (i.e., -10% scenario)

Expected Price …. $284.72 (Exp. Rtn +4.66%)

This is a very meager expected return for most investors: just $12.67 or +4.66% higher over the next year. Using options provides a safer way to play this.

In fact, an attractive play to value investors is to short at-the-money (ATM) or out-of-the-money (OTM) AMZN puts over the next two months.

For example, look at the July 17 expiry period, which is about two and a half months from now (74 days to expiry). It shows that the $265.00 put options strike price, 2.59% below Monday’s price (and my price target), has a midpoint premium of $10.65.

This means that an investor who secures $26,500 and enters an order to “Sell to Open” 1 put at $265 will receive $1,085 in the brokerage account. That represents an immediate short-put yield of 4.09%  (i.e., $10.85/$265.00) over the next 2 and ½ months.

That’s almost equal to the ER of 4.66% going long in AMZN over the next year. Moreover, the investor could potentially repeat this play 4.8x times over a year. So, the total expected return is potentially 19.63% (i.e., 4.8x 4.66%).

Downside Risks and Mitigation 

In addition, the breakeven point, if AMZN falls to $265 on or before July 17, is $254.15 (i.e., $265-$10.85). That’s 6.58% lower than Monday’s close and the potential ER over the next year would be:

$311/$254.15= 1.2237 -1 = 0.2237, i.e., +22.37% upside

In addition, to protect against the possibility of an unrealized loss (in case AMZN falls below $254.15, the investor could use some of the income to buy (and go long) puts at the $260.00 strike price:

$10.85 – $8.75 = $1.90 net credit, i.e., a breakeven point of $263.10. The most the investor could lose is $310 (i.e., $263.10-$260 x 100).

Another play, for more risk-averse investors, is to short the $250.00 put strike price, which is 8.11% lower than Monday’s close of $272.05. Since the midpoint premium is $6.00, the short-put yield is 2.40% (i.e., $6.00/$250.00).

Moreover, the breakeven point is $244, which is 10.3% lower. That could also provide a potential return over the next year of 27.5% if AMZN later rises to $311. It’s a safer way to play AMZN as the delta ratio is only 0.24, implying less than a 25% chance AMZN will fall to $250.00. Moreover, if the investor can repeat this play over the year, the expected return is 11.5% (i.e., 2.40% x 4.8x).

The bottom line is that shorting AMZN at-the-money or out-of-the-money puts is a safer and potentially just as profitable way vs. buying AMZN stock. This is based on the expected return analysis of both plays.

On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com