Easy as ABC: How To Trade Alphabet (GOOG) Using Options

  • Alphabet is a strong contender in the tech space, with several growth opportunities available to them
  • They are rapidly expanding their artificial intelligence and cloud platforms, while maintaining focus on their core competency, the search engine.
  • They have strong financials, with positive cash flows and continued revenue growth
  • They are an expensive stock to trade, but there are ways to implement bullish strategies using options to avoid high capital costs

Let Me Google That For You

Alphabet (GOOG) is a staple in the tech industry, and they are constantly engaging in acquisitions and various growth opportunities. Their position isn’t going to be knocked away anytime soon, as they have exposure to almost every new development in the space, ranging from artificial intelligence to self-driving cars.

However, the digital world continues to evolve, and it is increasingly important that Alphabet stays on top of the trends. Search and ad revenue remain key drivers for the company, but other mediums for search, such as voice assistants like Amazon’s Alexa, pose a big risk.

GOOG is currently trading around $1,200 per share, below it’s 2018 high of $1,291.44. However, despite the lowered price, the $1,000+ price tag pushes a lot of consumers out of the market, especially those with small capital accounts. But Alphabet is a good buy, offering a combination of strong financials and an innovative business platform.

Alphabet operates through two different segments, Google and Other Bets. The Google segment covers Advertising, Android, Chrome, Google Cloud, Maps, Search, YouTube, and more. The Other Bets segment includes the outside businesses that the company operates in, such as Access, Calico, CapitalG, GV, Verily, Waymo, and X.

Source: CB Insights

Google: Search and Advertising Still Dominate

The Google segment is the biggest revenue driver for Alphabet. Other Bets are entirely experimental, and are separate from Alphabet’s net income goals. Within their Google segment, Alphabet is putting a significant amount of resources into their Cloud Platform, Artificial Intelligence, and Advertising.

Within their advertising platform, the company has experienced an increase in Traffic Acquisition Costs, representing 23.09% of advertising revenues in 2018, a 1.89% increase from 2016 numbers. They experienced a large surge in acquisition costs to distribution partners, which has climbed almost 4% since 2016 to it’s current value of 13.19%. As mobile continues to grow in popularity, so will the TAC that Google carries. Maintaining relevance in the search and advertising space, despite the growing costs, is a top priority for the company, but the company is also devoting a large amount of resources to Cloud and Artificial Intelligence

Source: Google 10-K

Google Cloud: Third Place, But Not For Lack of Trying

Google Cloud offers Alphabet endless growth opportunities, as the power of the cloud is essentially untapped. Like Amazon and Microsoft, details about the cloud business are vague, but in their most recent earnings call, the company stated that they’ve “doubled the number of GCP contracts greater than $1M” with a “really nice uptick in the number of deals greater than $100M.” The cloud space is extremely competitive, as I discussed in my Microsoft article, and GoogleCloud is persistently in third place behind Microsoft Azure and Amazon AWS.

Source: ZDNet

Google had aggressive capital expenditures for 2018, outspending both Amazon and Microsoft with a $25.5B total for the year. That was 2.25x more than Amazon and 1.6x more than Microsoft. The CAPEX number was obviously for more than just cloud services, but the company has made it clear that the cloud unit is a priority for them, with the CEO saying that “the most sizeable (hiring) increases were in cloud, for both technical and sales roles“.

Source: CB Insights

The company has also been focusing on cybersecurity within the space, building out a “digital immune system” called Chronicle. Chronicle should help the company combat the security issues that will arise, and allow their Cloud business to continue growing across various industries. Google’s machine learning spin should help it to differentiate from Azure and AWS, which will bring more customers to the table as the computing process grows in complexity.

Building Out Artificial Intelligence

Artificial Intelligence encompasses both the Google segment of Alphabet, and their Other Bets. Google has resources devoted to AI development, and so do some of their experimental companies. Internally, Google is devoting a large amount of resources to building out machine learning and continually refining their search engine process through natural language processing.

Source: CB Insights

They’ve also acquired several key players in the AI space, including DeepMind, a strong force in the machine learning space. They have acquired companies that focus on natural language processing capabilities, which should help them with building out Google Assistant, a form of artificial intelligence, which currently has a second place rank among peers.

Source: Business Insider

It is important to note that Alexa isn’t immediately integrated into any smartphone, whereas Google is automatically on 400M Android devices, giving them easy access to their target market. Apple is still in the lead in this segment of the industry, which is bad news for Google, as every time someone searches for something with Siri, that takes search market share away from Google.

Google plans to change that. According to CEO Sundar Pichai, the company is planning to integrate Google Assistant into “every major device brand“. They are also building out a “Made by Google” line, with includes the Pixel, the Nest, Google Home hub, and was bolstered by their $1.1B acquisition of HTC’s smartphone segment in 2017.

With regards to innovation in the space, IBM and Microsoft lead the way in AI patents. Alphabet lags behind in 10th place, but leads the way in terms of acquisitions. They have acquired 18 companies this year alone, which is much more than the 5 companies that IBM has acquired.

Source: Financial Times

Alphabet has a strong focus on “radar-based gesture sensing and data transmission“, which they filed a patent for in 2017. This goes beyond controlling a device with simply voice, and allows users to use gestures as well. As Google continues to build out their voice assistant, their search functions will improve as well, keeping the company focused on their core competency, while expanding more into AI.

The Growth of YouTube

YouTube is a big growth opportunity for Alphabet, with over 1.8 billion active monthly users. This arm of the company is estimated to bring in $15B in net revenue, composing 10% of Alphabet’s total revenue base. The platform has come under fire recently, with problems of misinformation and the content of comments, among other things.

YouTube offers several different viewing options, the most popular being YouTube Premium and YouTube TV. YouTube Premium offers an “ad-free YouTube experience” at $11.99 a month. Youtube TV is what the company is banking on, targeting traditional cable users with cable network streaming and live broadcast television for $40 per month.

As YouTube TV continues to expand across the country, the subscriber base should continue to grow. Right now, they have surpassed 1 million subscribers, totaling ~$480M per year in revenue against overall YouTube’s total revenue of ~$15B. However, if the below graphic is anything to go by, teens will bolster YouTube to new heights over time.

Source: Statista

Alphabet: The Financials

Alphabet has a strong financial standing, with a 23.4% year over year revenue growth, and 2.5x growth in net income. They have strong gross margins, with a 56.48% metric for 2018 and a 22.5% net income margin. Profitability metrics are also strong, with 9.1% ROA, 11.61% ROIC, and a 18.62% ROE.

Source: Capital IQ

They have a strong credit health panel as well, with top scores in operational, solvency and liquidity. They have strong quick and current ratios. Their long term debt has increased only 0.38% since 2016, reflected in their debt metrics, carrying a 2.26% Debt to Equity and a 1.72% Debt to Assets ratio.

Source: Capital IQ

The company has strong cash flows, with upticks in operating cash and a positive net change in cash. The decrease in cash from investing was primarily due to the increase in CAPEX that was discussed earlier in the article. The company also repurchased a fair amount of stock, reducing available cash for investing. Overall, the company has experienced healthy inflows of cash, and are poised to continue on this trajectory in the future.

Source: Capital IQ

Conclusion: Alphabet is a Strong Company, But Expensive to Trade

Alphabet has managed to get a foothold in several industries, from quantum computing to integrated advertising for e-commerce platforms. The company has a strong foothold in most of the spaces that they operate in, and that should allow them growth opportunities, even if they aren’t the leading market provider. They are expanding geographically into India and Southeast Asia, and trying to repair relationships with China with a partnership with JD.com. Finally, they have plans to go into transportation and logistics, as well as get into healthcare through AI.

The company isn’t recession proof, but should be a good buy opportunity for those looking for decent exposure to the tech industry and innovation. However, buying one share of GOOG at ~$1,000 can quickly eat into portfolio exposure, especially in smaller accounts. Luckily, there are ways to replicate a bullish sentiment on a stock without buying the stock.

Trading Options on Google

Alphabet is a good candidate for a Bullish Diagonal, or Poor Man’s Covered Call. Here, we will replicate the purchase of the stock with by purchasing an in-the-money call at a longer term expiration cycle, and sell an out-of-the-money call in a near term expiration cycle. This is very similar to the covered call, but reduces the margin requirement, because we do not have to purchase the underlying stock.

Source: Tasty Trade

The Bullish Diagonal Spread: Poor Man’s Covered Call

The analysis is a simple outline of what can be done with this bullish diagonal, and can be adjusted with risk-return preferences and time constraints. This tactic prefers a move slightly to the upside, preferably above our current stock price. This also prefers a low volatility environment, that way the fluctuations won’t be so intense throughout the life of the trade. The below graphic details the advantages and disadvantages of the bullish diagonal. We are not using LEAPs in this analysis.

Source: Options Trading IQ

Tactic: Bullish Diagonal on Alphabet

Trading GOOG at a stock price of $1,200, we can sell the 30 delta 1250 strike that expires on April 26, 44 days from now, for a credit of $17. We can then purchase the in-the-money 70 delta 1100 call that expires on Sep 20 2019, 6 months from now, for a debit of $112.

  • Buy Sep 1100 call @ 70 delta for $112
  • Sell April 1250 call @ 30 delta for $17.

For comparison, if we bought the stock instead of buying a call, it would cost us $1,200 for 100 shares, which would be $120,000. Here, we are theoretically ‘purchasing’ the stock at $112 for 100 contracts (100 contracts equals 1 share), for a total of $11,200, by simply purchasing the long option. Subtracting the $1,700 credit received for shorting the 1250 call, we pay $9,500.

In the best case scenario, we can earn a 70.5% return on this trade in the next 40 days. If GOOG increases to the value of our short strike, 1250, we earn a maximum of $50, represented by the difference between 1,250 short strike and 1,200 current stock price. We can also tack on the credit received from the short call to this profit potential, an additional $17, for a best case scenario of $50 + $17, which is equal to $67, or $6,700 for the total trade.

Dividing the $6,700 into the total paid for the stock of $9,500, determines a 70.5% potential return on this trade. Comparing that to simply selling a covered call reveals how efficient the poor mans covered call is for a return on capital.

If we simply sold a call against GOOG, we would still collect a credit of $17.00 at a strike price of 1,200. Assuming the trade goes perfectly, we end up paying $118,300 for the trade, as we still have to buy 100 shares of stock, calculated by $120,000 minus $1,700 credit received. The return on capital in this scenario is only 5.7%, calculated by dividing the potential profit, still $6,700 into the $118,300 spent on the covered call trade. In the poor man’s covered call, we are paying 8.03% of what we pay for a true covered call, with a ROC that is 12 times higher.

Depending on which way you expect the stock price to move, you could move the short 1250 call up, for a more bullish strategy, or down, for a more bearish outlook. We would look to close the trade when the stock price goes well past $1,250 as the profit potential for the trade will diminish. If that does happen, the long call should appreciate in value due to the stock price increase, and our short call should gain some profit due to time decay. However, if the stock price doesn’t work in our favor, we can simply roll the short call down to a lower strike, or out in time.

There are several other bullish plays on Google that we can implement using options. However, the bullish diagonal call spread allows for a higher return on capital, and a lower margin requirement than its covered call counterpart. To exit the trade, we would simply buy back our short calls, and sell our long calls, and get bullish exposure at a much lower cost.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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