Related tickers: Netflix, Inc. (NASDAQ:NFLX), LinkedIn Corp (NYSE:LNKD)
The market has experienced quite a run up lately, and earnings season is usually a period of increased volatility and uncertainty. Making investment decisions in a context like this one can be more complicated than usual, especially when it comes to buying risky, volatile stocks. Protective puts can be a great alternative to let your profits run while still controlling the risks.
Buying Insurance
If you have been in the market long enough, this has probably happened to you already. You really like that company, but the stock has been rising steeply, so you decide to wait for a pullback before buying. That pullback never comes, and you painfully watch the stock rising from the sidelines for some time. After deciding that the price will probably never come back to those levels you wanted, you finally decide to make a purchase at much higher prices.
And then it happens: it can be an earnings miss, a bad decision from the company´s management, a market correction, or all of those things together. Some stocks can fall by 30% or 50% in a relatively short period of time, and that´s when you start believing that the market is rigged against you.
Let me be absolutely clear about this: I can guarantee that the market is not rigged against you. How do I know this? Because it´s obviously rigged against me, and they can´t target us both at the same time. The inevitable truth is that these kinds of things can happen to anyone anytime, and investors need to consider the risks when making decisions.
A protective put is simply buying the stock and also buying a put option on that stock. Think of it like insurance: it has a cost, so this reduces your gains if things go well and the stock rises over time. On the other hand, the put option gives you the right to sell the shares at a specified price for a period of time, so you can determine a maximum limit to your possible losses, should they occur.
On Risk and Return
Protective puts can make sense on all kinds of investments, but they are a particularly interesting choice when it comes to innovative growth stocks with plenty of upside potential and big underlying risks. This is precisely the kind of situation where gaining exposure to the company while still keeping risks at bay makes more sense.
Netflix, Inc. (NASDAQ:NFLX) is a quintessential example about these kinds of situations, the company was a market darling back in 2009-2011, and it went from below $30 in January 2009 to more than 300 in July 2011. But then came the Quickster debacle, followed by a streak of earnings misses and disappointing news by the company that took the share price back to the $50 area.
Now the company is back on its feet, the Quickster mistake is already in the past, subscriber growth is showing encouraging strength and the stock price is also recovering. More importantly, House of Cards has been a remarkable success, and Netflix, Inc. (NASDAQ:NFLX) is planning to release its second exclusive series, Arrested Development, on May 26. If this new launch confirms that Netflix, Inc. (NASDAQ:NFLX) has become a successful content creator, then there is no limit for upside potential.
On the other hand, the risks are also quite big. Content is expensive, business profitability is scarce, and the company is competing against players like Amazon.com, Inc. (NASDAQ:AMZN) with deeper pockets and a restless competitive thrive. There is a lot to gain, and also a lot to lose in a company like Netflix, Inc. (NASDAQ:NFLX), so a protective put may provide a smart approach to owning the stock.
Speaking about Amazon.com, Inc. (NASDAQ:AMZN), the business is amazing; the company has built a rock solid competitive position in online retail, while at the same time it expands to other areas with big potential like web services. Investors have been willing to look beyond current – lack of – profitability and focus on the long term opportunity, so the stock is trading at a stratospheric forward P/E ratio in the area of 75 times earnings estimates for next year.
The stock doesn´t necessarily need to come down, it can continue rising and trading at expensive multiples for years to come. But it does look very vulnerable in case there is a change in sentiment towards the company. If investors become less complacent about Amazon.com, Inc. (NASDAQ:AMZN), current valuation provides no downside protection, so a protective put may offer precisely that.
The same goes for a company like LinkedIn Corp (NYSE:LNKD), this is no smoke and mirrors social network stock; the company makes more than 50% of revenue from talent solutions, which is a much more proven and reliable business model than the typical pure advertising model most social networks are based on.
LinkedIn Corp (NYSE:LNKD) has more than 200 million global users, and nearly 16,000 companies pay for its services, so it has reached a level where it has become the unchallenged leader in the industry. And growth opportunities are far from over; LinkedIn Corp (NYSE:LNKD) estimates that the addressable market size for worldwide talent acquisition and staffing services is $27 billion, so the company has a lot to offer in terms of long term growth opportunities.
On the other hand, LinkedIn Corp (NYSE:LNKD) is trading at a sky high P/E ratio above 900; any sign of slowdown in growth or some other bad news could easily trigger a big selloff as the market prices the stock according to more modest expectations. This is another case in which a protective put may be a sensible idea.
Bottom Line
There is nothing magical or too sophisticated about protective puts, it´s actually quite similar to buying insurance on your positions for a limited time. This insurance may ultimately be worth it or not depending on what happens with the stock price, and no one knows for sure what the future brings.
But investing is not only about profits and losses; it’s also about finding a risk and return equation that fits your particular needs. Keeping this in mind, protective puts may be the way to go for many investors, especially in situations with high potential and above average risks.
Andrés Cardenal owns shares of Amazon.com. The Motley Fool recommends Amazon.com, LinkedIn, and Netflix. The Motley Fool owns shares of Amazon.com, LinkedIn, and Netflix.
