Getting Ahead of Yahoo!

Options might be the safest way to play one of next week's big tech earnings reports.
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With the company's earnings report just a week away, both the bull and bear cases for

Yahoo!

(YHOO)

seem to be mounting at once.

And the trading activity likely to follow the company's eagerly anticipated announcement could provide an opportunity for some investors.

For Yahoo! bulls, reason to believe comes mainly from the glowing reports that keep appearing about Project Panama, the new search-ranking system launched by the Internet giant in February. On Monday, Merrill Lynch cited research showing that click-through rates by Yahoo! were outpacing those of rivals by 9%.

"In our view, data supports our thesis

that Yahoo! can deliver significant improvements in search monetization, which we estimate to be a $1 billion plus opportunity (over 4 years)," wrote Merrill Lynch research analyst Justin Post, citing data from market researcher comScore.

Indeed, while Yahoo! management has said the real bottom-line impact of Panama wouldn't begin to show until the second quarter of the year, shareholders seem to be lining up anyway. Shares have rallied about 25% this year to $31.81.

Throughout the quarter, Yahoo! management has talked up Panama, which holds the promise of closing the gap in the amount per search that Yahoo! makes compared to rival

Google

(GOOG) - Get Report

. And investors will likely home in on further commentary during the conference call. "We remain positive on Yahoo!'s opportunity to improve search monetization by improving the relevancy of sponsored search results, which we expect to be the key theme of the 1Q conference call and driver of the stock post-1Q results," Post wrote. Merrill Lynch makes a market in shares of Yahoo!.

But in the wake of Yahoo!'s run-up -- the company is by far the best performing major Internet player for the year -- more-cautious voices are also emerging. On Monday, JMP Securities analyst William Morrison downgraded the stock, citing a number of problems that may check its ballooning valuation. JMP Securities makes a market in Yahoo! shares.

Even as Panama helps boost Yahoo!'s search advertising, it may be slipping in the display ad business where it has long taken its first-place position for granted, Morrison wrote. This could wipe out further gains in the stock. "We believe

graphical ad weakness could offset some of the upside from Panama during the first quarter and for the remainder of 2007," Morrison wrote.

What's more, investors may be overestimating how far ahead Google is in the amount it makes per search -- meaning that despite Panama's success, Yahoo! may not have as much ground to gain as is often thought. While estimates commonly peg Google as making 12 cents a search to Yahoo!'s 4 cents, those numbers are likely inflated, Morrison argues. He estimates the gap to be more like 3 cents to 1.5 cents.

Morrison also outlines other threats, including increased competition from rivals, like

IAC/InterActiveCorp's

(IACI)

Ask.com and

Microsoft

(MSFT) - Get Report

, which may step up their spending on advertising.

AT&T's

(T) - Get Report

veiled threats

to bail on its partnership with Yahoo! also could take a toll. Even if the telecom giant stays, it will likely negotiate terms that are much more demanding, Morrison writes.

Given Yahoo!'s lofty multiple -- the company trades at about 44 times forward earnings, including cash position and stakes in other properties -- investors may be inclined to take a short position in the stock. Yahoo! seems priced for perfection, and any hint of bad news could provoke a selloff.

But Yahoo! also has some serious momentum behind it. Along with Panama, the company has been introducing

a flurry of new initiatives in the mobile space. Just Tuesday, it

announced a new partnership with media giant

Viacom

(VIA.B)

.

Bullish prospects coupled with any surprises along the lines of the early introduction of Panama unveiled

during last quarter's conference call could cause the stock to rally further.

Yahoo! also has a lot of short interest for an Internet giant. According to the latest data available on Yahoo! Finance, 6.7% of Yahoo!'s float has been sold short, compared with just 1.6% for Google and 3.4% for

eBay

(EBAY) - Get Report

. In the event of a rally, a short squeeze could ensue as investors attempt to cover their positions -- thereby sending the stock higher.

But the days-to-cover ratio -- which measures short interest compared to the average trading volume of a stock -- is hovering around historical averages of 3.73, says Dylan Wetherill, president of market data Web site ShortSqueeze.com. This curbs the boost that Yahoo! shares would get from a short squeeze.

But it also means that investors are anything but confident betting on a tumble in Yahoo! shares, even given the run-up and stretched valuation.

The two large selloffs in Yahoo! stock back in July and September of 2006 were both presaged by jumps in the days-to-cover ratio, Wetherill notes. "During these times the short interest days-to-cover soared to 6 and 7, which is twice the normal range, and then experienced the powerful drops in stock prices."

Given the uncertainty surrounding Yahoo!'s stock price, investors may be best off using options rather than owning or shorting the stock outright. Put options for $30 that expire on May 18 are currently trading at 55 cents. If Yahoo! shares were to revisit the $28 mark they saw at the end of January, for example, investors holding them would be able to make 2.6 times their money.

An even bolder bet would be buying put options for $30 that expire on April 20 -- just three days after the earnings announcement. Still, these options trade for 35 cents and could prove to be a good bet in the event that shareholders get rattled by what they hear during the earnings announcement, for whatever reason.

On the other hand, the overall sentiment in the stock may make call options too expensive to be as attractive. Call options for $32.50 with an April 20 expiration date trade for 80 cents, while those with a May 18 expiration trade for $1.20.

But in light of Yahoo!'s gains this year, a bearish bet with a limited downside may be more interesting -- and profitable.