Name That Trade – $TWTR: Early Bird Gets the Worm

by Dan August 7, 2015 4:01 pm • Commentary

We will keep plugging away at this one. First things first, we have been long (and recently) wrong in Twitter (TWTR) in some shape or form since the spring, but we have used options to help manage the risk. The stock has been a trainwreck with what feels like no end in site for their losses.

Let’s refresh our recent history with the stock and its options:

On April 28th we executed a stock replacement strategy (read here) replacing a profitable long that we had from the low 30’s and sold in the high 40’s. We replaced those shares with options when the stock was $51 prior to Q1 earnings:

I like the idea of defining my risk into the event. I’ve been riding the stock higher on and off for some time and I still think the stock should work higher as the company is able to increase their user engagement/base and increasingly monetize that base.  Prior to Q4 results I bought the stock in the high $30s and rode it up to the high $40s.   Now with the stock just above $50 I think the risk/reward feels fairly even.  My bullish view on the company has a lot to do with its scarcity value and that a large web/media property will be able to get far more leverage. But that is not what the stock is going to trade on after tonight’s results, which could disappoint high expectations.

Therefore I’m selling my shares here at a profit and replacing them with this bullish but defined risk trade:

TRADE – Bought to open the TWTR ($51.00) May 50/60/70 call fly for 2.50

On April 29th shares of TWTR closed down 18%, closing at $42.27, and spending most of the next couple months in the mid $30s.  Losing $2.50 in the call fly, or about 5% of the underlying stock price, and thus avoiding 30% losses. While we were wrong on the direction, our caution about the event lead us to define our risk. We used options appropriately to express our view (in lieu of the stock we sold) and didn’t risk the profits we already had.

We are nothing if not persistent.

Following the stock’s downdraft post Q1 earnings we re-entered a long stock position with an average just below $40, but with the stock making new lows on a daily basis, approaching key long term technical support at $35, we again decided to swap out of stock and define our risk on June 9th (read here):

With few catalysts in sight, and the stock acting horribly, I am going to sell the stock that I have been averaging into since the $42 gap on April 28th, and replace it again with a defined risk options structure to give long exposure over the coming months.

New Trade: TWTR ($35.70) Buy Sept 35/45 call spread for 2.80

This trade structure is in the money and a spread, which is an attempt to offset a bit of decay as this trade is acting as a replacement for long stock and I don’t want to compound the problem with an out of the money structure that could decay to nothing if the stock goes sideways

That trade preceded the company’s announcement that CEO Dick Costolo would step down, and that was just about it.  Uncertainty about future leadership, followed by horrible user growth data reported on their Q2 results on July 28th, followed by what can only be classified by a horrible performance by founder and interim CEO Jack Dorsey and current (not sure for how long though) CFO Anthony Noto the stock declined 15% the next day and a whopping 25% losses since the close on July 28th. And now the stock is $1 away from its November 2013 IPO price.  Ugh.  The call spread detailed above is nearly worthless and has a very low probability of break-even as the stock would need a 40% rally by Sept expiration, and the only way that would happen is if the company were bought.

So for the second time in 3 months, defining our risk through  long premium strategy was again preferable to long stock with losses far less than that if I had held the stock.

So now what?  The smart thing to do is probably take the stock off of our Bloomberg screens and never look at it again.  But you know we are not going to do that.  

If you believe as I do that in the very near term the only way the stock is again above $30 is an announcement of a favorable CEO candidate, and that a round trip to their IPO price could signify a sentiment bottom, then we could be near an inflection point.

Options prices have come in hard since Q2 results as expected (30 day at the money implied volatility, blue below), but not as low as they have been following the last few quarters as realized volatility (how much the stock has been moving, white line below) has remained elevated.  Options prices seem fair in the near term, making long premium strategies attractive for those with a directional view:

from Bloomberg
from Bloomberg

Oh and the only way the stock is near $40 anytime soon would be a take-over or the announcement of a CEO like Sheryl Sandberg from Facebook, which seems very unlikely.

But sentiment couldn’t be worse, the business expectations have been reset to near zero and over the next 6 months a lot could happen.  The situation in TWTR is reminding me a bit of the first year in Facebook since its May 2012 IPO where investors were calling for CEO Zuckerberg’s head, Barron’s put a $15 price target on the stock, and the stock declined 60% from its high on IPO day before the story turned:

FB 2012 chart from Bloomberg
FB May 2012 to May 2013 chart from Bloomberg

So if you want to close your eyes at this point, make a bet that everything having to do with TWTR only has one way to go, then consider defining your risk while risking what you are willing to lose. Here is the trade we are considering in Jan16 expiration that would benefit from a new CEO, mild improvement in user growth / engagement trends and possibly even a takeover. We’re going to try to time this trade right at the IPO price of 26 which is likely to see some buyers (or at least have sellers take a break) and could be a short term inflection point:

Hypothetical Trade: TWTR ($27) Buy Jan16 30/40 Call Spread for $1.80

-Buy to Open 1 Jan16 30 call for 2.45

-Sell to Open 1 Jan16 40 call at .65

Break-Even on Jan16 Expiration:

Profits: between 31.80 and 40 of up to 8.20, max gain above 40

Losses: up to 1.80 below 31.80, max loss of 1.80 below 30, or 6.5% of the underlying stock price.

Rationale:  So maybe the third time is a charm, while hindsight is 20/20, our recent history with the stock suggests that defined risk call spreads are the way to go at this point.

Plain and simple, we have been wrong on TWTR in 2015, but we feel strongly that there is a certain scarcity value for what is a very unique social media property that is not being reflected in the company’s equity valuation.  This is a very special situation where we feel the reasons for our bullish view will be realized, but its clearly a matter from where. Stay tuned as we could see our price in the stock soon at which point we’ll pull the trigger.