Sold YHOO Vertical Put Spread

After getting the suggestion from a reader in comments section of my last post, I started looking at YHOO this morning.  The stock has a forward P/E ratio greater than 28 and has a lot of change on the horizon.  Part of that change is causing the misleading P/E ratio.  Alibaba is scheduled to go public soon and YHOO will be able to take out a large chunk of cash from the IPO.  We don’t know how much yet, but we do know it’s going to be big.  In other words, the valuation isn’t as high as it looks, but we don’t know how much better yet.  Also, after Alibaba IPOs, YHOO is going to have to figure out another engine for growth.  I think they’ll get the benefit of the doubt for another couple of months, so I decided YHOO was worth a trade.

The premiums for the near-the-money puts are pretty rich and that can be an indication of what trouble lurks ahead.  It isn’t always a perfect indicator since fear can be misplaced, but it made me come up with an alternate plan after just a glance at the chart and the premiums.  YHOO has had a great couple of weeks, after testing its 20-day moving average, it moved above its 10-day and 200-day moving averages again.  It was showing some weakness today, on an up day for the broader market, but it was bound to have a down day eventually.  The question, as always, is how much lower could it fall before finding support again?  Rather than risking a bigger than expected shift in sentiment, I decided to sell a vertical spread to limit my losses if the stock sank dramatically.  While YHOO was trading at $$37.79, more than $0.40 below its high of the morning, I sold four YHOO October $35 puts for $1.31 each and bought four YHOO October $33 puts for $0.68 each.  I received $245.67 after paying $6.33 for the option combination that I sold with a limit order for $0.63.

My first instinct was to sell a $3 spread and I thought about the $37/34 and $36/33 spreads, but I wanted my short strike to be below all of the moving averages I watch (10, 20, 50, 100 and 200).  I checked the profit and risk for the $35/33 vertical spread that I sold and the $35/32 combination.  The $3 spread would make more money per trade, but would also risk a bigger loss if the stock fell below my long puts.  I noticed that if I sold four combinations of the $3 spread, I’d make as much as I would by selling four $2 spreads.  However, I’d risk an extra $92 with the $3 spread.  It made my decision easy.  I saw no reason to risk more money to get the same profit that I could with the combination that I sold.

I’m not planning to take an assignment on the short puts if YHOO falls below my strike.  I’ll probably just take the loss it that happens.  If I was considering taking the assignment, I probably would’ve sold the $3 spread, because the annualized return, based on buying shares at $35 and not using my long puts, is greater with the lower strike long puts (11.67% vs 13.81%).

YHOO Vertical Put Spread Risk/Reward Breakdown

  • Potential profit: $245.67
  • Money at risk: $554.33
  • Potential return: 44.32%, 288.07% annualized using money at risk
  • Potential return: 1.79%, 11.61% annualized if I wasn’t hedged
  • Breakeven price: $34.39
  • Downside protection: 8.99%
  • Recent high: $38.21, hit before my trade today
  • Cushion from recent high: 9.99%
  • Expected support: $36.76 was the low last week when YHOO gapped higher.  It could be retested and at the same time retest the 200-day moving average and the 20-day moving average and a trend line of higher lows.  If that cluster of technicals fails to hold support, the 50 and 100-day moving averages should keep the share price from falling below the $35.25-35.50 range.
  • Position close goal/limit:  If I can get out within the next five or six weeks for a dime, I’ll take the profit and run, but that mindset could change based on how YHOO moves over the coming weeks.  If it falls for a solid reason, I’ll probably take an early loss and move on, but if it falls without a real catalyst, I’ll try to weather the dip.

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  1. Comment by Martin

    Do you roll spreads at all or do you just take a loss and when do you take it? Is it whenever it breaks thru your short put but stays above the long one (so still a small profit) or when both strikes are breached?

    Also I nominated you to Liebster Award if you want to participate. Just go to my blog for details.


  2. Comment by Alex Fotopoulos

    I don’t usually roll my spreads. In some cases, I could take a loss on the short put and close it out or if I think the stock/ETF is turning around, I might take the assignment and try to take a profit on the long put (if there’s any profit to be had). It’s a case by case decision.
    The same goes for timing. It depends on what’s going on, but I usually try to wait until expiration or at least the week of expiration.

    Thanks for the nomination! I’ll check out the details.

  3. Comment by GZ

    Alex, what would be your reasoning for YHOO to move up or down in 2 month time horizon?
    Mine are the following:
    1)Alibaba IPO turns out better than market anticipates;
    2)Some real news or just a rumor about takeover of Yahoo;
    3)Reversal of what has been a too much of general negativity and pessimism baked in YHOO stock (that is why it is so cheap on it’s components’ basis).

    1)The whole market gets a correction;
    2)Alibaba IPO becomes a dissapontment;
    3)Yahoo overpays for a next acquisition (like Tumbler).

  4. Comment by Alex Fotopoulos

    GZ, I agree with you on most of those, but don’t think there’s much of a chance that YHOO would be taken over. Outside of MSFT, who could/would do it?

    The biggest YHOO specific catalysts revolve around the Alibaba IPO for the reasons you noted. I think everything is on hold until then. There could be a sell-off after the IPO, no matter how good it is. The recent run higher might just be a build up until then.

    I’d like to see a couple of sizable smart acquisitions with their pending cash influx. I’m expecting this to be a bullish influence, but you are right – if it’s not a smart use of the money, Mr Market could punish the stock.

    I could see some multiple contraction if general market sentiment sours, but I don’t think YHOO will fall too far before value investors start scooping up shares. Even in a retracement, I don’t think it’ll fall below the July low around $33.

  5. Comment by GZ

    Besides MSFT, as this article points out, there is some logic for other companies to be interested in as well- FB, AAPL, or even Google.

  6. Comment by GZ

    There are 2 convincing articles posted in July by Eric Jackson on Forbes, I’m curious what do you think of them.

  7. Comment by GZ

    2nd one

  8. Comment by Alex Fotopoulos

    Thanks for the links. I hadn’t seen these before now.

    I think GOOG is a very long-shot. I’d rather see FB or AAPL go for something else, but those three have so much cash, they can do whatever they want. The trouble is that the YHOO lack-of-growth-weight would slow their overall growth and that could hurt their multiple. Less so with AAPL and GOOG, but FB would lose some growth-cred with YHOO rolled in.

    I hadn’t thought about Alibaba (or SoftBank) buying them out. Jackson makes a compelling case in both articles, even with YHOO’s lack of growth. I might have to add another put spread at higher strikes (or 1-2 naked puts). I want to wait a couple of days, but could add more by Thursday or Friday on any further weakness.

  9. Comment by GZ

    Yeah, I agree- no need to rush in, as you may get a better entry point later. I’ve owned Yahoo since those articles got published, so I’m sitting ok now. And just couple days ago, I sold Sept 26 $40 covered calls for $1.33, so obviously I’m more committed in YHOO than you are.
    On a side note- S&P 500 price action scared me a little bit, and then I just remembered that Sept. is a historically weak month for stocks, so I bought 1 contract (that is all I need for insurance, as my account is small)of SPY Sept 26 $200 put for $2.45, as VIX is quite low, I think it makes sense (at least for me).

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