How to keep participating in a stock's rally if you're getting concerned about valuation

Published Thu, Jun 20 202411:47 AM EDT

A great business isn't always a great investment if the price one pays is too high. I'll review how to handle this challenge with options. ARM Holdings (ARM) offers several technologies instrumental in AI applications, notably its advanced processor designs and intellectual property. The company's Cortex processors are often used in smartphones, tablets, IoT devices. Its R Series real-time processors are used in applications requiring high-reliability such as automotive and industrial control systems. ARM has several chips with AI applications. With these and other technologies, it's unsurprising that ARM Holdings has ridden the AI wave, up more than 170% over the past 52 weeks, outperforming the S & P 500 by nearly 150% over the same time frame. Operationally ARM Holdings is very well positioned. Its offerings are used in everything from handheld devices to data centers. But there are valid concerns about valuation. In this case, ARM Holdings is currently valued at about $174 billion, more than 56 times trailing 12 months revenues, and recent price action in particular looks extended. For those that would like to participate if the rally continues but were not in the name, it's a challenge to commit fresh capital at these prices. For those who are already in the name and may be reluctant to sell possibly for tax reasons or simply to adhere to the wisdom of "letting one's winners run" their may be a way to participate with slightly lower risk than purchasing (or continuing to hold) the stock at current prices of just over $173 a share. The trades For those who already own the shares, but want a downside buffer if the shares should fall, consider a "put spread collar". Such as the September $130/$170/$200 one illustrated here : Sold Sep. 20 $130 put Bought Sep. 20 $170 put Sold Sep. 20 $200 call One would purchase the September $170/$130 put spread, financed by the sale of the $200 strike call for even money. This would provide about $27 worth of upside from here, while providing $40 worth of downside insurance in the event that ARM Holdings pulls back. The risk/reward for those trying to play the momentum with fresh capital, but less concerned about the extended valuations at current prices could employ a synthetically similar strategy using a call spread risk reversal, purchasing an upside call spread financed in whole or in part by selling a downside put. By selling a downside put one is taking on the risk of purchasing the stock at the put strike, so this does carry equity like risk, but depending on the put strike selected, the purchase price could be significantly lower than the current market price. For example the $140/$175/$200 call spread risk reversal here incurs the risk of owning the stock at $140/share. Sold Aug. 16 $140 put Bought Aug. 16 $175 call Sold Aug. 16 $200 call Forty times price-to-sales isn't cheap from a value investor's point of view, but $140 is nearly 20% cheaper than the current stock price. A great price? No, but certainly a better one. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL'S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.