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Amazon (AMZN) reported excellent Q1 results on April 27, with higher revenue and free cash flow (FCF). This has made AMZN stock popular again with value investors as they project positive FCF going forward. As a result, investors can find good deals with covered calls and out-of-the-money (OTM) cash-secured puts.
Amazon said its revenue for the quarter was 9% higher compared to last year and its last 12-month (LTM) FCF improved significantly. In the latter case, the LTM FCF went from being negative (an outflow) of $18.6 billion in the LTM to March 31, 2022, to just negative $3.3 billion in the LTM to March 31, 2023.
This implies that sometime in the last year Amazon's free cash flow has turned positive. As a result, it's highly likely Amazon will likely report positive FCF in the next quarter unless the U.S. enters a major recession.
Free cash flow is important because it is what is left over after paying all cash expenses, including capex and working capital changes which are not included in earnings numbers. It shows the company is throwing off cash that can be used to buy back shares, make acquisitions, reduce debt, pay dividends, and/or just accumulate on the balance sheet.
For example, during the Q1 earnings call, Brian Olsavsky, Amazon's CFO, said this:
“Our operating cash flow for the trailing 12 months ended March 31st increased to $54.3 billion, up 38% versus the comparable period year-over-year.”
Moreover, the company said it has seen its supply chains, inventory purchasing, and payment cycles ease up, contributing to its overall cash flow profitability. That is why investors are confident that going forward Amazon can continue to report higher free cash flow.
Income Plays with Covered Calls and Cash-Secured Puts
Investors who own at least 100 shares in AMZN stock can short out-of-the-money (OTM) calls (i.e., “covered calls”) and create income since AMZN stock does not pay a dividend. For example, for the expiration period ending May 26, which is 28 days from now, investors can short the $119.00 strike price call options. That strike price is 8% higher than today's price.
This call option trades for $1.78 per in the midprice between the bid and ask price. This represents a yield of 1.62% on the closing price of April 27 of $109.82 per share.
For example, an investor who buys 100 shares of AMZN stock at $109.82, for $10,982, will immediately receive $178 when they enter an order to “Sell to Open” 1 call option at the $119 strike price expiring May 26. If that can be repeated each month for a year, the investor could make $2,136, representing a return of 19.45% on the original $10,982 cost.
Moreover, investors can short OTM puts and make a slightly higher income. For example, in the same option expiration period, the $100 strike price put options trade for $2.19 at the midprice.
This means that the investor who secures $10,000 with a brokerage firm can then enter an order to “Sell to Open” 1 put contract at the $100 strike price. The account will immediately receive $219.00. That is a premium-to-strike yield of 2.19% or 26.3% on an annualized basis if the trade can be repeated for a year. This is a much better annualized return than the covered call play.
Note that this strike price is almost 9% away from the spot price, which is slightly farther away than the covered call play. So, combined with the higher return and the distance from the spot price, this makes shorted cash-secured puts in AMZN stock more attractive. That is likely why investors now have 468 contracts in this strike price tranche.
Moreover, shorting puts has an inherent advantage over the covered calls assuming AMZN is likely to slowly rise over the next month. The possibility of investors having their options exercised is much lower than the covered calls.
The bottom line here is that investors can make income with AMZN stock shorting covered calls and cash-secured puts. There are benefits to using both methods.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
