The Deutsche Bank analyst’s upgrade of FB to buy from hold this morning is a great example of the recent sentiment turnaround in FB. His reasoning was that FB has “more revenue momentum” than expected, and his expectation for tomorrow’s event was for FB to show off a new search technology.
That’s all well and good, but where the heck was he 2 months ago when the stock was trading below 20?!?!
We became bullish on FB stock when everyone had left it for dead ahead of the November lockup expiry, with the stock trading around $21. We felt that there were not many sellers left of the stock after 3 months of basing around the $20 level, and anticipated that buyers were waiting for the end of the lockup period to get the all-clear signal to finally buy the stock. That did indeed turn out to be the case, though we did not trade that expectation as well as we could or should have.
In any case, looking at the situation today, all of a sudden everyone is now a Facebook bull with the stock above $30. But one of the fundamental tenants of trading is that price determines risk. It’s why we’re very careful about structuring our options trades to maximize our risk/reward and reduce our cost. It’s why we’re reluctant to get bullish into euphoric situations. And it’s why FB is a much riskier buy above $30 than below $20, in our view. In that context, what’s the trade setup for today?
First, the stock has risen up to an area of technical resistance, where previous holders are more likely to unload stock. Here’s the lifetime chart:
The 33 area served as resistance several times last May and June. If the stock spends some time digesting its gains over the next month, then the probability of a breakout above 33 would be higher in my view. But given that the stock is up so fast in 2 months, I think sellers will start to overwhelm the buyers here. While I expect a pullback, I don’t think it will be drastic, as the recent strength has been drive by mutual fund managers buying the stock (institutional ownership has been steadily rising), and that usually indicates some residual demand on any pullbacks. The technicals point to decent support in the 27-28 area.
I also don’t expect a bad earnings report on Feb 1st. Expectations were lowered enough last year, so I expect FB to likely beat. But I do have doubts about the optimism surrounding tomorrow’s announcement. Whatever is announced, the stock’s recent action seems to set up for a buy-the-rumor, sell-the-news event. There’s also alot of people that got plugged with stock on the IPO or bought it on the way down that will be sellers as the stock tries to go higher through the 30’s.
Finally, and most importantly, I decided on the following trade because of the setup in implied volatility, which I’ll explain in the Trade Rationale section below.
TRADE: FB ($31.30) Bought the Feb16th expiry 33/30/27 put butterfly for $0.64
-Bought 1 Feb 33 put for 3.25
-Sold 2 Feb 30 puts at 1.62
-Bought 1 Feb 27 put for 0.63
Break-Even on Feb16th Expiration:
-Profits between 27.64 and 32.36, max profit of 2.36 at 30
-Losses of up to 0.64 between 27 and 27.64, and between 32.36 and 33, max loss of 0.64 below 27 and above 33
TRADE RATIONALE: The Feb implied volatility for FB is at 60 (on the upper end of its 40-70 range since IPO), and the earnings implied move for the stock is around 10-11%. However, I think FB has its most stable investor base since the IPO, and also expect less volatility around earnings as the number of reports and visibility for the company increases. But most importantly, the reason I like this trade is that I’m only risking 0.64 to make 2.36, and my profit range is within the 27.64 to 32.36 range, which seems like a good range based on the technicals going forward. In other words, this trade is a good way of selling FB implied volatility, but at low risk.
I also chose to center the put fly around the $30 level since it’s an important psychological level for the stock, and a level that has a lot of option open interest, which might make a pin on expiry more likely. Finally, the trade’s intrinsic value at initiation is around $1.70 with the stock at $31.30, whereas I’m only paying 0.64 for the trade. I’m starting out ahead by about $1 on the trade, mainly because the options market has priced implied volatility so high.