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Wednesday, May 13, 2009

Leap into Google with Option Call Spreads

Let's face it: Google owns the internet search space. How many times have you heard people say "Yahoo it" or "MSN it" ? Well if you have it probably isn't too often. I often find myself saying "Google it" when referring to searching the web.

Google has held up well through this economic downturn, and I believe as the economy gets healthier, bids for clicks will increase, and as a result Google's share price should as well. However clicks are not the only way Google generates money anymore. The growth of Google Checkout is also generating a steady stream of income (a good example of Economies of Scope). Recently an analyst upgraded the price target on GOOG to $600 a share, with some analysts even claiming it to be as high as $750 in 1 year. A recent article states that Google's Android mobile OS is expected to grow at 900% in 2009 beating expected growth for both Apple and Blackberry.

In my opinion Google is a solid company going forward; they were able to add $2 billion in cash over the last quarter which is a big plus, especially in this economy. There are several other factors why I think Google is a great company, but this is not the intention of this article.

So on with the strategy: a Google bull call spread: (prices as of close Tuesday May 12, 2009- prices should be adjusted daily).

I checked both the Google Leap 10 and 11 call options. I believe $600 is a feasible share price for Google in 18 months so I'll use that as my upper limit for the leap 11, and I'll use $530 for the upper limit for the Leap 10.

Strategy # 1: Buy the GOOG Leap 10 $400 Call and sell the Leap 10 $530 Call. To open this strategy would cost roughly $3,400. However if Google is above $530 come January 2010 expiration this strategy would net a profit of $9,600 or 282% gain. To break even Google would need to be at $434 come January expiration.

Strategy #2: Buy the GOOG Leap 11 $400 Call and sell the Leap 11 $600 Call. To open this strategy it would cost roughly $6,000, and this strategy would net a profit of $14,000 or 333% if Google closed above $600 at expiration in January 2011.

I have implemented the first part of strategy two. However, I am bullish on Google; therefore, I'd like to complete the call spread at a later date, when Google is 10%-15% higher. After all, I do have over 600 days to sell the call.

According to the current Delta value if GOOG were 10%-15% higher, it would yield an additional $9 to $13 for the $600 contract. As GOOG's share price increases, so will the Delta value (assuming Google to increase sooner rather than later), therefore the premium on the $600 call would be even higher than the calculated value.

I am bullish on Google, therefore the way I look at it is:

For strategy 1: for every spread position opened I would have 8.5 shares of Google (let's call it 9.) If Google gets to $530 I would have made a profit of $1,170 or 34.4%. Google needs to get to $438 in order for this spread strategy to make $58 more than owning 9 shares of Google common stock.

For strategy 2: for every spread position opened I would have 15 shares of Google. If Google gets to $600 I would have made a profit of $3,000 or 50%. Google needs to get to $471 in order to make $35 more than owning 15 shares of Google's common stock.

However, in both cases Google would need to go to $0 a share in order to lose the same amount of money from the common shares as if the option expires dead (less than $400 at expiration).

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