Far too often, investors get stuck into patterns. They see a hot new stock and try to attach it to how another, much larger company started out. Finding the next Apple or Pepsi is almost too appealing to ignore. We all love good stories. But good stories don’t always make good investments.
Shopify (SHOP) is a perfect example. The company is taking on big business – specifically Amazon – by offering marketing, advertising and sales platforms to small startups. If you’ve ever launched a new product or service all by yourself, you know how difficult it is to get setup and started.
For hundreds of thousands of small businesses, Shopify makes life much easier. Amazon does sell third-party products. But to get listed and then seen is a truly challenging maze to navigate. With Shopify, you can build your own store, manage marketing and even link to social media… all for a small fee.
This strategy has paid off big for the company. Sales have grown from just $205 million in 2015 to $1.1 billion last year and $1.3 billion over the last 12 months. Unfortunately, the company hasn’t been able to turn that into a real profit yet.
Oh, it is starting to turn a slight profit… estimated to be about $69 million for 2019. But that’s not really even pennies compared to how large the company’s price tag has gotten.
So far, in 2019, Shopify’s stock has risen 163%. It now carries a market cap of $41 billion. Meaning, it trades at 31 times its sales and nearly 600 times its projected earnings. Even for a fast-growing momentum play, that’s absurd.
The reason, at least the only one any bull can give right now, is that it is simply following in Amazon’s footsteps.
You may recall, Amazon reinvested its revenues so completely as it was growing, that it took nearly two decades to turn a profit. Now that it has started to let that money filter through its income statement, it is one of the most profitable companies in the world.
Many feel Shopify could repeat that history. But that would be a mistake. You see, Shopify is a solid company with a brilliant platform. But it isn’t Amazon.
Amazon’s strength as a rocket-growth play was that it operated in a virtually unlimited space. It was able to move from books to clothes to toys and beyond. It could truly get a piece of nearly every sector of the economy… not just in the U.S. but around the world. And everyone knew after the first several years that it would eventually start retaining its revenues.
Shopify doesn’t have that size of playing board. Its customers grow out of its platform once they are big enough to hire their own IT department and large marketing staff.
That’s not to say Shopify is a bad company or can’t continue to grow at a tremendous rate for quite some time. That’s to say its stock represents an opportunity that isn’t really there. That share price growth is simply investors’ hope that it turns into another Amazon eventually. But it won’t. And investors have even less patience than they did 15 years ago.
With an economic slowdown affecting most of the world already… and many worried in the U.S., small business spending isn’t likely to keep up with Shopify’s hopes. A company with no real earnings and only aspirations to be the “next Amazon” isn’t going to hold up well. And with its incredibly share price performance, investors are more likely than not to start taking profits off the table.
This creates a great short-term opportunity, however, for those who know where to look.
A Strategy For Short Term Bears
A bear put spread is a type of options trade that involves buying a put option on a stock you deem will fall in the short term and selling a second put with a lower strike price.
This produces a net debit to your account, but far less of one than a straight put or shorting shares directly would. You see, the income from the sold put helps offset the cost of the first one… thereby reducing the total amount at risk.
This offset does come at the cost of some potential profits. If shares truly collapse, profits are capped as share prices fall below that second strike price.
You can see how it plays out here:
Source: The Options Industry Council
For Shopify, this trade makes tremendous sense. First, its current share price on top of its incredible recent performance would make a simple trade in a put far too expensive. But by offsetting that cost with some income, it makes this a solid conservative trade on a stock that’s just risen too far too fast.
And as for those capped profits, that’s not a huge concern. No one is suggesting that Shopify isn’t a solid company with plenty of growth ahead of it. A devastating collapse isn’t likely on the table. But a period of profit taking and consolidation definitely are.
Meaning, this trade probably won’t give up much if any of the profits it is set to take in.
Let’s look at a specific example to see just how much can be made here…
A Specific Trade on SHOP
Right now, a trader could buy a September 20 $365 put for $21 per share and sell a September 20 $355 put for $16.65 for a cost of $4.35 per share. Since each represent 100 shares of SHOP, that’s a total amount at risk of $435.
Now, for the trader to lose that, shares of Shopify would have to continue defying gravity for another full five weeks. With new “risk-off” trading seizing the market, that’s incredibly unlikely.
If shares fall to just where they were last week, the trader would capture his full profit potential. To find that, take the difference in strike prices ($365 – $355 = $10), and subtract the cost ($10 – $4.35 = $5.65). On 100 shares, that’s a maximum profit potential of $565.
In other words, if shares took just the tiniest of moves down, the trader would be sitting a 130% return on the amount he risked. To lock in that full amount, shares would have to retreat just 2.7%. SHOP can move that much in a day with no problem.
So, despite the clear market enthusiasm for SHOP, using this contrarian options strategy could prove to be just as lucrative as timing the rally we’ve seen this year.