Name That Trade: $ZNGA – Options on an Option

by Dan June 14, 2013 1:08 pm • Commentary

Here is a preview of what I will be discussing tonight on Options Action on CNBC tonight at 5:30 pm est:

Earlier today in the MorningWord (below) I laid out the case for taking a shot on shares of ZNGA given how poor the sentiment is, 72% of their market cap is in cash, and given recent moves in once out of favor names like BBRY and GRPN could present an opportunity for an asymmetric move to the upside on the least bit of good news.

For all intents and purposes, given the cash cushion, the stock is basically a long term option on the company, which is why I decided to express my bullish view via long stock (bought this morning at $2.80) instead of one of our fancy options structures.   But regular readers know we just can’t help ourselves from being a bit fancy from time to time and we wanted to lay out a trade structure that offered a very favorable risk reward and one that we would look to put on for a credit if and when the stock sold off to $2.50, or about their cash level.

Theoretical Trade Structure:  ZNGA ($2.80) Sell the Jan14 2.50 Put to Buy the Jan14 3/5 Call Spread for Even Money

-Sell 1 Jan14 2.50 Put at .37

-Buy 1 Jan14 3 Call for .50

-Sell 1 Jan14 5 Call at .13

Break-Even on Jan14 Expiration:

-Neutral bwtn 2.50 and 3.00 no gain or loss

-Profits btwn 3.00 and 5.00 of up to 2.00, max gain of 2.00 above 5.00

-Losses of up to 2.50 below 2.50, max loss of 2.50 at zero

Payout Diagram:

Screen Shot 2013-06-14 at 10.54.15 AM
from TradeMonster

At even this trade works as a long delta position with some room to the downside as protection. Ideally we’d look to put this trade on a little lower for a credit which means if the stock goes nowhere a small profit can be made.

Trade Rationale:   As I mentioned above, and below, the downside risk is defined, and the potential for a massive move higher far outweighs the potential for the stock to get cut in half or go to zero.  Capping your upside is not entirely the best idea in a situation like this, but the potential profit given the lack of premium makes the structure very attractive.  Additionally, when I do put this trade on, hopefully at better prices (a credit) at a lower entry point, it will not replace my long stock position, as I will want to keep a component of the trade that will not be capped on the upside.



MorningWord 6/14/13: Down, But Not Out, On The Farmville – $ZNGA, $GRPN

9:24 AM EDT – JUNE 14, 2013 BY  (EDIT)

MorningWord 6/14/13:  Catching sentiment shifts in unloved stocks can be one of the most satisfying feelings as a trader/investor.  The only problem with doing so is that more often than not you will be early.  Just as stocks tend to overshoot on the upside when things are euphoric, things can be dramatic on the downside as unrealistic fears of losing everything can cause investors to get sloppy.  In the last year or so there have been more than a few once-loved or hype technology stocks that have been left for dead only to see massive resurgence in investor interest. If you are going to rely on sell side research or a pundit on tv to identify the turn you will likely be too late.

Lets look at GRPN for example, the stock was upgraded this morning by Deutsche Bank from a Hold to a Buy and slapped with a $10 twelve month price target.  The street ratings now stand at 4 Buys, 12 Holds and 7 Sells with an avg 12 month price target at $6.40 or 6.5% below last nights close.   The company has a quarter of its market cap in cash and no debt and they actually make money. I am not making a bullish case for the company, but with nearly 9% short interest and a revenue base of over $2 billion expected to grow at 10% a year for the next few years, I think it is safe to say that the stock got a tad oversold last year at $2.60 down from its $20 ipo price in late 2011.

Now this analysis is not exactly helpful with the stock up 150% from the November 2012 lows, but it is interesting to note that the sell-side sentiment shift is largely the result of price action that has been dictated by investors bargain hunting rather than the other way around.  And that’s the point to get “2 or 3 baggers” as they say in the biz you are gonna have to do what very others are willing to do, you are likely to be early and often second guess yourself.  I will also add one very important point, much like we think about long premium options trades, this sort of investing should be limited to a small and speculative portion of your overall portfolio as the last thing you want is your stock holdings to look like the island of misfit toys.

Last week on CNBC”s Fast Money Halftime Report Enis mentioned ZNGA as his final trade, a stock that he is starting to dip his toe in the water with. Much like GRPN at the lows, the stock is hated by Wall Street analysts (3 Buys, 18 Holds and 3 Sells), down dramatically from post ipo highs, and in the mix of management/business model turmoil.  But the most important point I would make is that the company has ~70% ($1.67 Billion) of their market cap in cash and only $100 million in debt.  Trading at $2.80, ex cash I think you could safely say this is a fairly cheap long term option.  We are getting long some down here with the idea that we will be early and likely have to sit with a loser for a while till the rest of the investment world gets hip to the potential sentiment shift.

Is ZNGA a sure thing?  Of course not, there are no sure things in this business.  But it’s a situation where the odds are skewed quite favorably for a buyer at these levels.  That’s our goal – looking for situations where the odds are in our favor, and trusting that over time, that leads to an overall positive outcome for the portfolio.  ZNGA’s one such situation, and if it does work out, prices will move far before most analysts change to a bullish stance.

New Trade: ZNGA Getting long at $2.80