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Social Media Investors Could Generate 53% Annualized Returns Without Taking a Big Risk

It's no secret that the social media arena has been a difficult place for investors. Stocks like Zynga (NASDAQ: ZNGA), Groupon (NASDAQ: GRPN), Angie's List (NASDAQ: ANGI) and a handful of others have been on roller-coaster rides. Even the most popular name in the game, Facebook (NASDAQ: FB), wound up being one of the biggest disappointments out of the gate.

At the heart of the volatility for these stocks is the debate between "great concept" and "viable profitability." Investors tend to fall in love with great concepts, wether it be shiny phones that can do everything short of launching a space shuttle, or plastic shoes with holes in them, investors always want to be ahead of the "next best thing." And that's what drives prices higher for new concept stocks. The underlying belief that this could be it!

Everyone wants to own the next great concept, and for a while, social media looked like the place to be. Yet the fundamental question of whether these companies can produce reliable profits remains. Even if everyone in the world is using your product, that doesn't necessarily mean that you're going to turn a profit. And without profits, stock prices will eventually wither.

So the big question still to be answered for social media is whether profits will grow to match the bullish expectations, or whether this industry will struggle with competition, low barriers to entry and slim profit margins.

I certainly don't have the answer. So the big question still to be answered for social media is whether profits will grow to match the bullish expectations, or whether this industry will struggle with competition, low barriers to entry and slim profit margins.

Today, I want us to take a look at Yelp (NYSE: YELP). After an erratic first year of trading, the stock has settled into a reliable bullish trend as investors become more comfortable with the long-term fundamental picture.

The company has yet to turn a yearly profit. Analysts expect it to basically break even this year (losing $0.04 per share), and begin to generate positive earnings in 2014. On the sales side, the company is expected to grow revenue by 54% in 2013, and analysts expect an additional 40% revenue boost in 2014.

So it looks as though there is strong fundamental growth within the company, and the relative technical stability in the stock is encouraging from a trading perspective.

Recently, YELP pulled back a bit within the context of an overall bullish market, giving us the opportunity to buy at a cheaper price. When a stock pulls back, the volatility premium for option contracts typically increases, which means we also get a more attractive price to sell our calls. This leads to higher income and more protection for our capital.

Yelp Stock Chart

At this point, we can pick up shares of YELP for $25.29. At the same time, I want to sell the YELP June 25 Calls, which are trading at about $2.25. Remember, we want to buy the stock in 100-share lots, and sell one call contract for every 100 shares of stock that we own. With both sides of this trade in place, your net cost should be about $23.04.

Selling the calls obligates us to sell the stock at $25 per share, provided YELP is trading above this level in 59 days when the calls expire. This means that we will recognize a loss of $0.29 per share on the stock, which is more than offset by the $2.25 we received from selling the calls.

If all goes according to plan, our profit for this trade should be $1.96 per share -- an 8.5% return in 59 days. If we repeated a similar trade every 59 days, we could net a 52.7% annual return -- a great profit, especially considering the fact that we actually take on less risk than a traditional investor.

In fact, YELP can drop all the way to $23.04 (our net cost for the entire trade) and we still wouldn't recognize a loss.

If the stock were to drop to this level between now and June 21, we would not be obligated to sell our shares at $25. Instead, we would simply turn around and sell either July or August calls, netting us more income for the trade and protecting ourselves from any additional weakness in the stock.

For long-term investors in social media, the jury is still very much out. There are serious questions about which companies will survive, which ones will emerge as the dominant players, and which will be considered "second-tier" companies.

But for us as nimble traders, there is a high-probability opportunity to capture small pieces of profit over and over, accumulating very attractive returns with much less uncertainty and risk.

As always, please let me know how you are doing with this strategy. Send your emails to Editors@ProfitableTrading.com.