New Trade (FB): Overfilled on FB IPO? Cheap, Low Risk Way to Get Your Money Back

by Dan June 1, 2012 2:45 pm • Commentary

Here’s a Preview of what I’ll be discussing on tonight’s Options Action on CNBC at 5pm:

On Tuesday we made the case why ratio call spreads looked attractive in the newly listed options of FB (see below).  Since then nothing has changed in our minds as far as the attractiveness of this trade, but we will add one little wrinkle to the thought process.  WE THINK THIS TRADE STRUCTURE COULD BE PARTICULARLY ATTRACTIVE TO THOSE WHO ARE LONG THE STOCK, SITTING WITH LOSSES AND WANT TO ADD SOME JUICE ON A MOVE BACK ABOVE 30.  Here’s the trade…

The ratio spread I bought on Tuesday (below this post) was in July and it was further out of the money.  The trade I am going to lay out below is in August as I want to isolate what I see as really the only identifiable catalyst for the stock (barring a massive rally in the market) which will be their first earnings report as a public company that should fall in August expiry.

TRADE: FB ($27.75) Against Long Stock – Buy Aug 30 / 34 1x 2 Call Spread for .10
  • Buy 1 Aug 30 Call for 2.10
  •  Sell 2 Aug 34 Calls for a total of 2.00 (1.00 each)

Break-Even on Aug Expiration:

Losses of .10 at 30 or below, losses of up to 0.10 between 30.00 and 30.10, gains up to 3.90 between 30.10 and 37.90, and losses of up to 0.10 between 37.90 and 38.00.  Losses on the ratio call spread 1 for 1 with the stock above 38.00 (but presumably offset by any long stock position you have if you pair this trade with long stock).

Trade Rationale:

Sentiment is obviously very poor in the name, and there appears to be some “hate selling” going on at the moment.  We would be nervous actually stepping in to buy the stock here, as it is still an almost purely speculative bet given how little trading history and earnings history there is to go on.  Having said that, this ratio call spread allows us to only lose 0.10 if stock keeps going lower, and gives us a chance to make up to 4.00 on any stabilization and recovery in the story.  In addition, the options trade only loses money above 38, which we view as quite unlikely in the next few months given the number of investors who would love to get out of this IPO for flat.


Original Post, May 29, 2012

Options on Facebook started trading this morning and the action so far has been fairly brisk.  As of noon, over 135,000 total options contracts have traded (58.5k calls & 77.5k puts), while the most active lines are the June 30 puts with over 13,000 trading, and the June 32 & 34 calls with around 8,000 traded.

Implied vol out of the gate is fairly rich to say the least, with at the money vol of about 60, which makes it by far the richest among all large cap tech stocks that we look at.  Having said that, Facebook has only had 1 day where it has moved less than 3%, which was the artificially created +0.61% close on the first day due to the underwriters supporting the stock.  It should calm down a bit after its headline-laden start, but 60 vol implies a little less than 4% per day, which does not seem crazy by any means.

To be brutally honest, we don’t have a strong view on the stock just below $30.00, we would probably be more inclined to buy it than sell it at current levels, but the supply/demand characteristics going forward remain relatively unknown as there appears to be a fair bit of “hate-selling’ for those who got plugged on the IPO.   The unknown that remains in my mind is when do some of the “big boys” who drastically cut their interest in the deal in the days/hours leading up to the IPO finally come in to buy?  The flip side of that is the company has accelerated its lock-up and we will likely see a secondary to manage further insider selling within the next 3 months.

We are looking at a few ways for those looking to play for a pop to do so in a fairly low premium way.  As we said above, with implied vol starting off quite high, this will be a difficult task to achieve.   But with premium elevated and skew fairly flat, we think there is a very good opportunity to initiate ratio call spreads, as we think the way out of the money calls are just too expensive.

TRADE: FB ($29.55) Bought July 33 / 38 1×2 Call Spread for .65
  • Bought 1 July 33 call for 1.35
  • Sold 2 July 38 calls for a total of .70  (.35 each)

Break-even on July Expiration:

Profits with stock btwn 33.65 and 38 of up to 4.35, max gain at 38 of 4.35, pay-out trails off btwn 38 and 42.35.

Losses of up to .65 btwn 33 and 33.65 and btwn 42.35 and 43. I am effectively short stock above 38, but I have gains of 4.35 so I really have losses above 42.35 on July expiration.


Given that Facebook’s issuance price of $38 will likely act as massive resistance going forward (as all the people who bought at that price have since seen the stock go down by more than 20%), we are comfortable selling 2 of the 38 strike calls because we think there is a low likelihood that the stock makes it above there anytime soon.  When doing a ratio spread like this the usual concern is gap risk though your short strike (waking up to find the stock has drastically moved through that strike overnight). In this case, with so much stock likely to go at 38, (think of how much MS was forced to buy that first day) that risk in FB is very small. Though we normally don’t like to leave ourselves with open-ended risk (thus we almost never trade 1×2 spreads), this is a unique situation created by the stock falling hard through a very big IPO price.

1×2, Margins and Risk

Like we mentioned, we’re comfortable with the tail risk of the 2 times short 38 line because of the nature of this story. This spread could just have easily been capped risk-wise by turning it into a butterfly, where one is only wasting 10c to cover their upside risk by buying the 44 calls.