Amazon.com, Inc. (Nasdaq: AMZN) has been one of the best performing stocks of all time. Since its initial public offering (IPO) in 1997, the stock has delivered gains of more than 63,000%. But, when looking at a long-term chart of the stock, it is reasonable to ask if anyone other than Jeff Bezos, the company’s CEO, has held the stock since its IPO.
When looking at the chart, the size of the gain is the most obvious feature. The stock appears to have gone virtually straight up for more than twenty years. The next chart takes a different view. Looking at a weekly line chart of the stock’s performance makes it obvious the price gains have not been delivered in a straight line. There has been quite a bit of back and forth price action with declines following rallies.
The stock price has fallen more than 90% at one point, after the internet bubble burst in 2000. AMZN has pulled back by at least 30% on at least 18 different occasions. Given these numbers, is it reasonable to believe a trader would have owned the stock through the draw-downs? Many individual investors set strict stop loss rules and sell whenever prices fall 20% or 25%. A 30% decline would result in selling by many investors, even those who believe in the company’s long run earnings potential.
The down side volatility of AMZN is one problem investors face with the stock. For many individual investors, the stock’s share price is a real problem. The stock is priced near $1,000 a share. That is an extreme, but even stocks priced above $100 a share can present challenges to individual investors. With a small account, it can be difficult to trade a stock with a triple-digit price because it presents a problem of diversification.
A small investor may have only $2,000 of trading capital. This allows for the purchase of just one share of AMZN, for example. If a stock is priced at $100 a share, they might buy 10 shares and commit half their account to the trade. This is not prudent since it is always possible an individual stock can crash on any given day. The odds of the market crashing are much smaller and that is why diversification is a widely accepted strategy for minimizing the risk of a large loss on any one day.
Rather than buying the stock, some investors look at options. But, these can also be expensive. In the case of AMZN, a call option near the stock’s current price expiring in one month might cost $3,000. This demonstrates an important reality about options pricing — stocks with high share prices tend to have high options prices.
With the shares and call options out of reach for many investors, they ignore stocks with high prices. As the dramatic gains in AMZN make clear, this can mean missing out on large gains. Fortunately, there is a low cost strategy that can be used to benefit from stocks like this. It involves options and is known as a spread.
There are multiple strategies that involve spreads but we will focus on a single idea in this article to be sure the idea is clearly explained. We will look at variations of the strategy in other articles.
Let’s assume AMZN has pulled back and you are bullish. To benefit from a bullish outlook with options, you could buy a call or sell a put option. We covered the problem with buying a call on AMZN. A similar problem exists for selling puts. Your broker will require you to maintain a certain amount of money in your account to guarantee that you will be able to meet the obligations of the contract. This amount can be about 20% of the option’s exercise price. For AMZN, your broker could require a margin deposit, in cash or securities, of more than $2,000 to write a put. This is, again, an expensive trade for a small investor.
One way to reduce the required margin is with a spread trade. We will use real numbers to illustrate this idea. We will assume you have a $2,000 account and are approved for options spread strategies in your account.
AMZN is trading at about $980. You believe it will go up. To benefit from that you would like to sell a $950 put option. That put is trading for about $20. Since each contract covers 100 shares, selling this put would generate $2,000 in income (ignoring commissions which should be small when trading options). If AMZN is above $950 when the option expires, you keep the premium as your profit. You would need a margin deposit of at least of $19,000 to open that trade. That is clearly beyond the amount of money available in the account.
But, you notice there is a $945 put option trading at $15. This would cost $1,500 to buy. You realize that if you sell the $950 put and buy the $945 put, your risk is limited to the difference between the two exercise prices. That is $500 in this case. You would generate $500 in income after selling the $950 for $2,000 and buying the $945 put for $1,500. That means you are risking $500 for a potential gain of $500. You could also close the trade early to decrease the size of any potential loss. The size of the largest possible loss is usually the amount your broker will require as a margin deposit for these trades. In this case, that is $500. Now, AMZN is within reach of small investors.
There are three important possible outcomes in this trade. AMZN could be trading above $950 at expiration, below $945 at expiration or between those two prices.
If the stock is above $950, the put you sold expires worthless and the put you bought is also worthless. This means you gain $500, the difference between what you earned when selling the put and what you paid to buy the protective put. This is the best possible outcome.
The worst possible outcome occurs if AMZN is below $940 when the options expire. Let’s assume it falls sharply, to $800. The put you sold is then showing a large loss equal to the difference between the market price and the exercise price or $150 in this case. The contract covering 100 shares shows a loss of $15,000. But, the put option you bought is also worth the difference between the market price and the exercise price. That amounts to $14,500 in this trade. That’s the maximum loss of $500 that you accepted when opening the trade.
Now, there is no rule that says you have to let the options expire. You could close them early by entering orders to buy the $950 put and sell the $945 put. These trades reverse the action you took to open the position. Let’s say you did that when the stock was at $943. In that case, the loss would be less than $500. It would depend on the market price of the options but it is likely it would be less than $200.
The trade described here is called a bullish put credit spread. It is bullish because you implement it when your outlook on a stock is bullish. It uses put options to benefit from the bullish outlook. It is a credit spread because opening the trade resulted in a credit to your account. It is also possible to use a debit spread to benefit from your market opinion and we will cover that idea in a future article.