Name That Trade – $FB: Poking to New Highs?

by Dan July 18, 2014 3:16 pm • Commentary

Last night Google reported Q2 sales that were better than expected despite missing slightly on EPS and showing a decline in gross profit margins.  The results in general were highlighted by ad sales deriving from search results, and a 33% increase in clicks on ads on Google sites which include YouTube and mobile.  Investors seem fairly happy, sending the shares up 4%, now down only 2% from the all time highs made in February.

For those looking to extrapolate strong mobile search results, the logical extension would be Facebook (FB), which is scheduled to report their Q2 after the close on Wednesday July 23rd.  The options market is already implying about an 8% move, or about $5.50 in either direction, which is a tad shy of its avg over the last 8 qtrs of about 10%.  Last night succinctly drew the potential connection between accelrating mobile ad sales at Google to Facebook:

Facebook is aggressively nipping at Google’s heels: Google’s share of US mobile ad spending dropped from almost 50 percent in 2012 to 41.5 percent in 2013, according to eMarketer. Facebook, on the other hand, rose sharply: its market share of US mobile ad revenues jumped from 9 percent in 2012 to 15.8 percent in 2013. The US mobile ad market will almost double in 2014, eMarketer projected.

FB is up 25% year to date, and 150% over the last year.  The stock sports a $175 billion market cap, trading at 15x this years expected sales – whoah.  A little rich for my blood.  But admittedly it has been an amazing secular story over the last year, demonstrating fabulous growth in mobile advertising that is likely to continue to have legs for qtrs, if not years to come.  To be frank, this stock is not my cup of tea.  I don’t like their products or their management, and think that they will likely have more competition than they can deal with in the not-too-distant future.

That being said, on the heels of Google’s Q2 results, and the stock’s set up, it could be poised to make another run to the previous highs on the slightest bit of good news.  I would not be a buyer of the stock here, but here is a trade that I think would be very suitable for stock replacement from current levels, or for those looking to make an outright bullish bet with defined risk.  Most of the bullish trade structures (aside from short put spreads), such as at and out of the money calls and call spreads, do not look attractive.  Again, one would need to get timing and the magnitude of the move correct.  This is a tough way to make money in a low vol environment trading events – lots of things have to go right just to break-even.  This is why in-the-money call butterflies look attractive in Facebook:

Hypothetical Bullish Trade: FB ($68) Aug 65/72.50/80 Call Butterfly for 2.25

-Buy 1 Aug 65 call for 5.00

-Sell 2 Aug 72.50 calls at 1.55 each or 3.10 total

-Buy 1 Aug 80 call for .35

Break-Even on Aug Expiration:

Profits: between 67.25 and 77.75 make up to 5.25, max gain of 5.25 at 72.50

Losses: of up to 2.25 btwn 65 and 67.25 & btwn 77.75 and 80, max loss of 2.25 below 65 and above 80

Rationale:  Implied vol in FB options is fairly elevated (but not nearly as high as the last few quarters). But the spread between realized volatility (how much the stock is moving) and implied volatility (the price of options) is quite wide, and the risk to long premium directional trades would be less than expected movement post earnings, making it hard to make money in that scenario:

FB 1yr chart of 30 day at the money IV (blue) vs Realized Vol (white) from Bloomberg
FB 1yr chart of 30 day at the money IV (blue) vs Realized Vol (white) from Bloomberg

What the in-the-money call butterfly compensates for is the vol crush after results, as the in-the-money calls that I am long will be less sensitive to the post earnings vol decline.

For instance, the break-even on this call butterfly is below where the stock is trading, so if the stock has a muted move, I could actually make money on the trade, even if it were down slightly, while offering a very wide range to the upside for near term profitability (a range of about 15% ).

From a technical perspective, the stock has made a very nice measured re-tracement of the March to early May declines and looks poised for a breakout on the slightest bit of good news on next week’s call:

FB 1yr chart from Bloomberg
FB 1yr chart from Bloomberg

That being said, we chose the 72.,50 strike as the meat of the call fly as it is the prior high from March and we chose the 65 strike as a stop on the downside as it would mark a near test of the sharp uptrend that has been in place from the June 2013 lows.  I WOULD NOT TO BE LONG ON A BREAK BELOW THAT.

So this trade could be a very nice long stock alternative or for those looking to play for near term gains up 10% to 15%, but want to do so with defined risk. Or simply a trade for those looking to ride Facebook to new highs without risking a lot of downside if the entry is entirely wrong.

We have not put this trade on, but would prefer to do so closer to the company’s report to get a better sense for where the stock will be heading into the print.  We will be sure to take a closer look prior to results.