How to Profit Alongside Amazon.com

This conservative option strategy can lead to sizable profits in the months ahead.

Jun 30, 2014 at 2:45PM

At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in elite businesses. When I find one of these rare Tier 1 enterprises, I tend to add to them repeatedly over time as favorable opportunities arise. It's a strategy that has helped us achieve a time-weighted return of 80.91% since Tier 1 was launched on Sept. 1, 2011, compared to the S&P 500's 72.80% return during that time. And today, I believe we have one such opportunity in Amazon.com (NASDAQ:AMZN).

The opportunity
Amazon's stock is down about 20% from its 52-week high as investors are once again questioning Amazon's ability to generate sustainable profits from its enormous revenue base. But I believe they're underestimating not only the e-commerce titan's potential for margin expansion, but also its massive growth opportunities.

I consider Amazon one of the rare companies that an investor can buy and add to over a period of not just years, but potentially decades. It has one of the strongest competitive moats I've ever seen, and its growing stronger by the day. Amazon's tremendous scale and reach allows it to offer a broader selection of products at cheaper prices and via a more convenient shopping experience than any of its rivals. That's a powerful competitive advantage that positions the company extremely well to profit from the Internet shopping megatrend, which, with only about 6% of retail sales conducted online, is still very much under way.

Amazon is further expanding its moat through its Amazon Prime program. With each new feature Amazon adds to Prime -- such as the recently launched Prime Music -- the service becomes more valuable to customers, making them more likely to renew. The more "sticky" Prime becomes, the more purchases consumers are likely to make through Amazon. And with a recent increase in its Prime membership fees, we should begin to see profit margins expand in this important segment of Amazon's business.

Amazingly, in addition to its massive global opportunity in e-commerce, Amazon has another megagrowth business in Amazon Web Services. In fact, Andrew R. Jassy, the head of AWS, has stated that "we believe at the highest level that A.W.S. can be at least as big as our other businesses." That's incredible, especially when you consider that Amazon's "other businesses" include its core retail operations, which in time may grow to make the e-commerce titan the largest retailer on the planet. And, importantly, operating margins at AWS are believed to be far higher than at Amazon's core retail operations, meaning that the growth of this business should lead to margin expansion over time.

The strategy
I want to increase Tier 1's ability to profit alongside Amazon, but in a more conservative manner than simply buying shares to account for the possibility of further downside in the months ahead. To do so, I will be selling "mini" puts on Amazon. With this option strategy, I will be paid a premium to enter a contract to buy 10 shares of Amazon at a specified time and price. Specifically, I will be selling the Amazon January 2015 $330 puts, currently trading at about $30 per share. If Amazon is trading at or above $330 on the Jan. 17, 2015, expiration date, the puts will expire worthless. And the $300 I receive in premium ($30 per share times 10 shares) will amount to a 9% gain on the $3,300 at risk ($330 per share times 10 shares).

If Amazon is trading below $330, I will be obligated to purchase shares at an adjusted price of $300 ($330 strike price minus the $30 per share in premium), or about 7% lower than today's $324 price. So, in effect, I would be buying shares of an outstanding business at a better valuation than is possible by simply buying shares today. And, importantly, I'd be very happy to purchase Amazon shares at that adjusted $300 price.

Finally, between the time I sell the puts and the expiration date, I will have the option of buying back my puts or rolling them to other strike prices and/or expiration dates. And so, with this put writing strategy, there will be many ways to earn a profit.

The Foolish bottom line 
Wall Street is once again questioning whether Amazon can continue to grow as it has in the past. Many investors have headed for the exits, pushing down Amazon's share price in the process. But, therein lies our opportunity. By taking advantage of temporary market fear, we can profit alongside this elite, Tier 1 enterprise. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program that's designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be writing Jan. 17, 2015, $330 puts on Amazon in the Tier 1 Portfolio.

Leaked: This coming consumer device can change everything
Imagine the multibillion-dollar sales potential behind a product that can revolutionize the way the world shops and interacts with its favorite brands every day. Now picture one small, under-the-radar company at the epicenter of this revolution that makes this all possible. And its stock price has nearly an unlimited runway ahead for early, in-the-know investors. To be one of them and hop aboard this stock before it takes off, just click here.  

Joe Tenebruso manages a Real-Money Portfolio for The Motley Fool and is an analyst on The Fool's Stock Advisor and Supernova premium service teams. You can connect with him on Twitter @Tier1Investor. Joe has no position in any stocks mentioned.

The Motley Fool recommends and owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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