Beware AI stocks trading at rich valuations. How to profit from a pullback using options

Published Wed, May 1 202411:43 AM EDT

Investors have grappled this quarter with how to value an AI-focused company based on its future revenue potential against its current spend to develop the product. We saw the downside to high capex spending without a clear path to revenue growth in META's decline after earnings. While Palantir (PLTR) is not a direct parallel, it is an AI focused company that trades at a rich valuation. These types of valuations are at risk as we grapple with the notion of potentially even higher rates from the Federal Reserve. I see further downside in many of these stocks that have lost significant value over the past couple of weeks such as PLTR. After gapping higher above $21, PLTR has failed to see any follow through on the initial momentum. Moreover, momentum has now turned negative and its testing the $21 level as support, alongside a series of lower lows and lower highs. This suggests that we could break below the $21 support and target the $17.70 gap level underneath. Since PLTR barely turns a profit, using EV to sales is a better valuation metric, which trades at over 21x. This is extremely high given that analysts only expect revenue to grow by a modest 13% over the next few years. This puts PLTR in the same valuations as the fastest growing tech companies with growth numbers that are half as fast. There is a substantial risk that companies with such rich valuations will receive a haircut as interest rates potentially rise even further. The trade With Implied Volatility on the lower end of the spectrum, despite reporting earnings next week, I'd use a simple put option to gain significant downside exposure with limited risk. I'm going out to the May 31 st weekly and buying the $22 Puts for $1.95. This would risk a total of $195 per contract if PLTR stays above $22 at expiration, with a max reward of over $2,000. However, a move down to our $17.70 gap fill level at expiration, would result in a 120% gain on the put options. 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.