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.