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The Professor
Charles Pennington

6/14/2005
Nasdaq Options, by Charles Pennington:

Barron's column "The Trader" by Kopin Tan in the May 2 issue (subscription required) gives an informative graph of both the levels and the earnings of the Nasdaq Composite from 1997 to present.

Back in 1997, the Composite was around 1200, with earnings around 20.

Today the Composite is around 2000, with earnings around 80.

So in 8 years, the earnings of the Composite have grown by a factor of 4. That's a growth rate of around 18%. The P/E is about 25. (It was about 60 in 1997 and about 120 near the peak in 2000.) The earnings yield then on the Nasdaq is about 4%, a hair less than the yield on the 30 year Treasury.

So the Nasdaq Composite's earnings have grown at 18% through what I would have guessed would have been a difficult period, which included a big tech meltdown. If the Nasdaq Composite earnings grow by anything like 18% going forward, then in 10 years or so the level that we're at now will be considered very low. How can people still believe that we're in a bubble?

A second point is that long-term Nasdaq call options, as they're priced now, look like very good buys, especially for anyone sharing the bullish view outlined above. To support this, I add a little counting below. (I'll be looking at QQQQ and the Nasdaq 100, rather than the Composite, but that should be close enough.)

Right now QQQQ is at about 38, and you can by January '07 LEAP calls with strike price of 38 for $4.70. They expire in about 18 months. Below are listed the last 13 non-overlapping 18-month returns for the Nasdaq-100. Also shown are the percentage return that you would have made on a 18-month at-the-money leap option for each period assuming that it was priced at about 13% of the strike price, as the options are currently.

PeriodNDX % ReturnHypothetical % call return
12/03-6/05         4             -70
6/02-12/03         39            200
12/00-6/02        -55            -100
6/99-12/00         2             -85
12/97-6/99         132           915
6/96-12/97         46            254
12/94-6/96         67            415
6/93-12/94         10            -23
12/91-6/93         10            -23
6/90-12/91         38            192
12/88-6/90         34            162
6/87-12/88         -6           -100
12/85-6/87         43            231
Average            28%           151%
Stdev44%           283%
Count              13             13

If history is a guide, then on average you'll almost triple your money on these calls. Twice in 13 times will you lose your entire shirt. You lose a sleeve or two on four other occasions. On average though you'll have many shirts in the end.