Inflated Valuation Sets Up Bullish Options Strategy on Amazon Stock (AMZN)

From an investment standpoint, e-commerce and tech juggernaut Amazon (AMZN) makes a compelling case for itself. Over the past several years, the company has evolved to become a necessity of modern life, not just a medium of convenience. Therefore, it’s not unreasonable to consider steadily building a position in AMZN stock, assuming that its market value should be elevated years down the line.

On the other hand, extracting alpha from a trading perspective represents a whole new ballgame. Especially with options, the idea is about deciphering the ebb and flow of AMZN stock, irrespective of the broader fundamentals. In other words, trading AMZN doesn’t necessarily involve dissecting income statements and cash flows. Such metrics help establish context but don’t signal where the security may head next.

Instead, options traders must rely on probabilities—specifically, the likelihood of the target security reaching certain price thresholds within a defined time period. By understanding the terrain, a market participant can make informed decisions about when to hold and when to fold.

For AMZN stock, the present environment appears probabilistically muted, thus warranting a credit-based bullish options strategy.

Assessing the Numbers Behind AMZN Stock

As a relevant and popular tech giant, it should be no surprise that AMZN stock enjoys an upward bias. On any given week, the chance that a long position in AMZN will be profitable is about 54%. This figure is calculated by dividing the number of positive-return weeks by the total number of weeks in the dataset — pretty simple stuff.

However, not all sentiment regimes feature the same probability of long-side success. In other words, during certain fear and greed cycles, the probability of upside could vary significantly from the baseline. In cycles where the odds rise to 60% or 70%, an incentive exists to take a debit-based wager. These situations involve the trader paying a premium for a specific outcome to materialize.

The problem with AMZN stock right now is that in the past 10 weeks, the security printed a “4-6-U” sequence: four up weeks mixed with six down weeks, with a net positive trajectory across the period. This pattern (known as market breadth) occurred 25 times in the past decade. In those cases, the following week saw positive price action only 52% of the time, with a median return of 3.39%.

Unfortunately, this ratio doesn’t really provide traders with much of an edge because it also means that in 48% of cases, AMZN stock declined in the subsequent week (with the median loss coming out to 2.36%). Effectively, AMZN at this juncture is a coin toss.

As such, a debit-based options strategy would be imprudent. This is because you would be paying a premium for what practically amounts to a 50/50 wager. Instead, a credit-based strategy may make more sense because you would be selling uncertainty (rather than buying probability in the case of a debit trade).

Further, a credit trade — essentially a position that starts from a cash inflow state — has the advantage of two ways of winning: either the security moves in a favorable direction, or it doesn’t move at all. In contrast, a debit trade must move toward a specific outcome to be profitable. Since we’re uncertain about the forward trajectory of AMZN stock, a credit play may be appropriate.

Drafting Yield for Playing Defense

Those who want to make productive use of Amazon’s pensiveness may consider selling the 202.50/200 bull put spread expiring May 30. This transaction involves selling the $202.50 put and buying the $200 put, for a net credit received of $68. Should AMZN stock stay above the short put strike price of $202.50 through expiration, the trader would keep the entire credit. If so, that would translate to a yield of 37.36%.

It’s not a bad way to generate income, but a solemn word of caution should be noted. If AMZN stock declines in value, the credit seller would take a loss due to the sold put. Regarding the above 202.50/200 put spread, the maximum loss is capped at $182. This is the notorious tail risk of bull put spreads — you’re risking nearly 3x the potential maximum reward.

So, why would one bother to participate in such a questionable enterprise? While credit-based strategies clearly have their risks, under certain trading setups, they make more sense than debit-based approaches. Again, with AMZN stock, the current 4-6-U setup doesn’t provide a probabilistic edge. That would render a debit-based approach as a game of chance rather than a contest of mathematical skill.

When uncertainty is the dominant motif of a particular setup, it may behoove the trader to sell the uncertainty rather than to buy it. That’s why the bull put spread might make sense here, even with the threat of the tail risk.

Is Amazon Stock Expected to Rise?

On Wall Street, AMZN stock carries an overwhelmingly bullish consensus based on 47 Buys and just one Hold rating over the past three months. AMZN’s average stock price target of ~$240 implies approximately 18% upside potential over the next twelve months.

See more AMZN analyst ratings

Playing the Cards That AMZN Deals

While investing in Amazon may involve deciphering narratives, when it comes to trading options, it’s all about probabilities. I’m interested in the likelihood of AMZN stock realizing specific outcomes without becoming sidetracked by biased narratives and backward-looking data. The current issue with AMZN is that it does not provide a probabilistic edge. As such, astute traders should consider a credit-based approach.

In contrast to a debit-based strategy, a credit trade involves starting from a cash inflow position. Essentially, you are selling the uncertainty, which is arguably a smarter solution than paying a premium for a 50/50 wager.