Name That Trade – $TWTR: Building a Bird’s Nest

by Dan June 19, 2015 2:24 pm • Commentary

Twitter (TWTR) has itself a sort of Fairy God Father in the form of their pre-ipo investor Chris Sacca.  Sacca, on his VC firm’s blog (LowerCase Capital) has issued two very detailed posts critical of management and current strategy. One from June 3rd, prior to CEO Costolo’s resignation, What Twitter Can Be and the other just this week on management’s less than stellar explanation of their management transition, What Twitter Says, and What Investors Hear.  Although Sacca has stated he has no interest in the CEO job, he appears to be keeping the pressure on TWTR’s management and board in both traditional and non traditional ways.

Regular readers of RiskReversal, and viewers of Fast Money and Options Action on CNBC should be familiar about my views on TWTR, summed up here with links from a post last week:

I’ve been fairly vocal about my disappointment that the company can’t seem to meaningfully grow their user base and user engagement.  The halt in growth, leads me to believe the company should be part of larger media or on-the-line property like Google (GOOG) to help achieve the scale they will need to compete for ad dollars with Facebook (FB).  I am not going to go into more detail for purposes of this post, but read earlier posts on the topic herehere, here and here.

I think what is fairly clear at this point is that TWTR’s board and management are no longer in denial about the short-comings of the product and the lack of user growth and engagement. But in the meantime as they sort out leadership and tweak product strategy the stock could trade in a fairly sloppy (think volatile) manner.  When the company reports Q2 results in late July I think it makes sense to assume at least slightly worse than expected results with a guide down for Q3.  My thoughts last week right after the news of Costolo’s departure was that the company should get a sort of “mulligan” on results until they find an acceptable replacement.  But I would add one thing, a stock that has performed as poorly as TWTR could be very vulnerable if the broad market were to weaken.  While M&A is clearly a focus of agitators, sitting around and waiting for it is an entirely other story.

Which brings me to a conversation I had yesterday with a guy who is a great investor in public tech stocks who was less familiar with TWTR and wanted to pick my brain on the story. He has not been involved with the stock, but in the mid $30s, and after all of the controversy he is starting to get interested.  He, like me, thinks the quarter, guidance and news flow regarding management transition could continue to be sloppy, but he also believes the potential for m&a could be real and makes a lot of sense for a handful of potential acquirers.

Rather than step in here and buy the stock and wait for a lot of things to happen I detailed a trade structure for him to consider that would offer a little wiggle room to the downside, and leverage to the upside despite the most probable likelihood being a small gain or loss.

Here was the Hypothetical Trade: 

TWTR ($36) Buy Dec 32 / 42 Risk Reversal for Even Money

-Sell to open 1 Dec 32 put at 2.50

-Buy to open 1 Dec 42 call for 2.50

Break-Even on Dec Expiration:

Profits: above 42

Losses: below 32

Neutral: no gains or losses between 32 and 42

Rationale: This trade structure servers as stock alternative and provides a wide range of break-evens on both the up and the downside on expiration, but prior will have mark to market losses as the stock moves closer to the short put strike, and gains as the stock moves closer to the long call strike.

There are a few ways to think about getting long exposure at the moment:

  1. You could buy stock here, and be wrong short term on entry and find yourself having to make a decision on the stock if it re-tests this weeks lows at $33.50, or 7.5% lower.
  2. You could define your risk and buy calls or call spreads and possibly have the stock settle in until so meaningful news and watch your premium bleed.
  3. You could sell puts or put spreads and take in premium, but have limited upside. Which is why I like the idea of combining some of these thoughts and arriving at a strategy that gives me a buffer to the downside, leverage to the upside, and mitigates premium decay.

The options market is currently suggesting a 30% chance that the Dec 32 puts will be in the money on Dec expiration, and 37% chance that the Dec 42 calls will be in the money. So when you think about this trade it has a far less likelihood of small gains, but a far greater likelihood of less of a loss if that is the ultimate outcome at Dec expiration.