Shares of Nvidia (NASDAQ:NVDA) continue to rip higher in front of earnings. NVDA stock is now up over 108% so far in 2020 as it trades at all-time highs. Undoubtedly some of the red-hot rally is warranted given the earnings and revenue growth. Shares have now come too far, too fast however. Time for a pullback in an overvalued and overbought Nvidia.
Nvidia is certainly no bargain from a valuation viewpoint. The current price-to-sales (P/S) ratio now stands at almost 26x. This is the loftiest level for NVDA stock in the past decade. It is also greater than 95% of the companies in the semiconductor industry where the median P/S ratio is just 2.2! Other valuation metrics, such as price-to-earnings (P/E) and Price to Free Cash Flow, are at similar extremes.
InvestorPlace contributor Chris Tyler had a similar viewpoint on the fundamentals from his research piece on Aug. 5. He noted that the 53x forward price-earnings ratio and staggering 22x price-sales ratio was concerning. Since then, NVDA stock has added on an additional 40 points, making the valuation concerns even more worrisome. While momentum can carry stocks to extremes, at some point valuation does matter.
NVDA Stock Technical Take
The technicals are flashing red for NVDA stock. MACD is well over 2 while 9-day RSI is back above 80. Momentum is nearing the highest readings of the past year.
Bollinger Percent B just broke above 100. Shares are trading at a huge premium to the 50-day moving average of $405.04. They are also trading at the biggest premium to the uptrend line since the rally began. The previous times all these indicators aligned in a similar fashion marked a significant intermediate-term high in the stock.
Source: The Thinkorswim® platform from TD Ameritrade
Comparative Contrast
Nvidia stock is getting extremely extended on a comparative basis. Normally Nvidia is highly correlated to the Semiconductor ETF (NASDAQ:SMH). This makes sense given that NVDA has the second-largest weighting in the ETF. Since the pandemic lows in late March that correlation has broken down considerably.
SMH has gained a very impressive 70% since bottoming on March 18. NVDA stock, however, has ripped higher 140% — or double that amount — in the same time frame. Look for Nvidia to revert to the mean and be a relative under-performer over the coming months.
Source: StockCharts.com
Earnings are due Aug. 19 after the market closes. Expectations are for $1.95 in EPS on $3.65 billion in revenues. The whisper number, or what the analysts really think, is for $2.01 in earnings per share. Implied volatility (IV) is heightened in the options that expire this Friday due to the impending release.
It is hard to envision the rally will continue unless earnings, and more importantly guidance, are an absolute upside blow out. Shorting the stock outright in front of earnings is too risky for my taste. Luckily the options market provides a defined risk way to structure a bearish trade and take advantage of high levels of implied volatility.
So to position for a post-earnings pullback in NVDA stock, a short-term put calendar spread trade makes probabilistic sense.
Buy the Aug. 28 $450 puts and sell Aug. 21 $450 puts for a $3 net debit
Maximum risk on the trade is $300 per spread. Ideally Nvidia closes near $450 at expiration this Friday to realize the maximum gain. The trade structure also captures some rich term structure of volatility edge by selling a 73 IV and buying a 62 IV for an 11 vol point difference.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a weekly option and volatility newsletter can visit the Options and Volatility Newsletter website.
