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Amazon (AMZN) stock is slowly rising ever since the April 27 release of its Q1 results. AMZN stock closed at $116.25 on Friday, May 19, up 5.9% from $109.82 on April 27. Confidence that Amazon is making positive free cash flow (FCF) is growing. This makes shorting puts and calls very profitable for enterprising investors.
In fact, we wrote about this FCF development in our recent Barchart article on April 28, “Amazon Results Surprise with Higher Revenue and FCF, Making AMZN Stock Popular Again.” We pointed out that management said its operating cash flow for the trailing 12 months (TTM) ended March 31st increased to $54.3 billion, up 38% versus the comparable period year-over-year.
Nevertheless, last quarter its FCF was still negative or an outflow. Free cash flow differs from operating cash flow mainly in that it deducts capital expenditures. Last quarter the company had an outflow (i.e., negative FCF) of $3.3 billion in the TTM to March 31. That was much better than the prior year's $18.8 billion outflow, but it was still negative - i.e., it used up the company's cash balances.
Investors are now gaining confidence that its FCF will soon turn positive. When that occurs expect to see AMZN stock much higher. And assuming the U.S. and the global economy do not go through a major recession in the next year that will likely happen, as it has in the past.
Shorting OTM Puts and Calls
In our last article on AMZN stock, we discussed shorting out-of-the-money (OTM) puts and calls in AMZN stock for the period ending May 26. That expiration was 28 days in the future, but as of today is only 6 days from now. Both of these trades have worked out well, but especially so in the case of the cash-secured OTM put short trade.
For example, in our article, we suggested the $1.78 premium for shorting $119.00 strike price calls, when AMZN stock was at 8.36% lower at $108.72, was valuable. In fact, today, even though AMZN is higher at $116.25 (but still below the $119.00 strike price) the premium is lower at 81 cents.
That means investors have already made 97 cents shorting the $1.78 call premium, or 54.4%. And keep in mind that the $1.78 premium received in this covered call trade represented a yield of 1.63% (i.e., $1.78/$108.72). That represented an annualized return of 19.56%.
But the short put trade has been even more profitable. For example, the $100 strike price puts traded for $2.19 and the strike price was 8.95% out-of-the-money. Since AMZN stock has risen, these puts are now trading for between 3 and 4 cents per put option.
In other words, investors have made over 98% on the short put trade. At the time the trade yielded 2.19% on the strike price, or 26.9% on an annualized basis.
Rolling the Short Put Trade Over for Next Month
That means investors may want to now close out that trade by buying back the May 26 $100 strike price puts for 4 cents and then rolling the trade over for next month.
For example, the $107 strike price puts that expire on June 23 trade for $1.14 per put contract. That strike price is almost 8% out-of-the-money and expire in 34 days from now.
This means that the investor who secures $10,700 with a brokerage firm can then enter an order to “Sell to Open” 1 put contract at $107.00. The account will immediately receive $114 which thus represents a yield of 1.065% (i.e., $114/$10,700).
If that can be repeated each month for a year, the investor will make a 12.78% annualized return. That can complement the return the investor may make by holding AMZN shares. In fact, since AMZN does not pay a dividend, it is a way of generating income from the investment.
Moreover, as you can see from the options chain above, an investor can make significantly more income by taking slightly more risk. For example, the $110 strike price, which is still 5.38% out-of-the-money, has a premium of $1.75. This means that even if AMZN stock stays above $108.25, the breakeven point (i.e., $110-$1.75), the investor will still have a profit on or before June 23.
That represents a distance of 6.88% from $116.25 today that AMZN stock would have to fall to the breakeven point. And if AMZN keeps moving higher with investors' faith in its FCF turning positive, or even less negative, that point will not likely occur.
The bottom line is that shorting OTM AMZN stock puts now looks like a decent trade for long-term investors.
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. For more information please view the Barchart Disclosure Policy here.
