In the eight trading days of its young life on the public street, the stock has plunged roughly 26% while generating lots of activity and volatility along the way—not to mention plenty of financial pain for all the investors who were "lucky" enough to get a slice of the original plump offering.
Taking a stock position in FB can be quite scary and I get that. In fact, I wouldn’t trade a single share of FB stock, not even with your money.
However, on Tuesday, stock options were newly listed on FB and began trading shortly after the opening bell. And unlike the butchered IPO debut, options trading and all the technology platforms ran like clockwork.
The options volume on its first day was staggering with over 350,000 contracts traded in total! The front month alone, June expiration, traded over 160,000 contracts. The liquidity and sheer volume makes FB certainly attractive to market participants even though the underlying stock seems quite risky and unpredictable.
Today, I’m going to share with you an options strategy that you can use right now that will not only give you the confidence to trade in a scary stock like FB, but also clearly defines your overall risk before you even enter the trade.
After learning this strategy, you’ll never have to be fearful or intimidated by risky securities that might interest you but otherwise reluctant because of the perceived risks. Hopefully, what I share with you will have an empowering effect on your trading and investing.
The strategy is low risk and cost efficient which can generate high returns on your investment. And it won’t rip your face off (pardon the pun) in the case that you’re completely wrong as long as you maintain proper leverage, meaning the amount of contracts you trade or the capital committed.
Even better, this strategy can be applied in both directions depending on your outlook. You can structure the trade if you’re bullish and are looking for FB to rebound after the sharp selloff from the $38 IPO price.
Or, you can jump on the bearish side betting that the stock is still ridiculously overvalued and that the company will struggle living up to all the hype sending the stock price even lower.
I’m not going to make the argument either way, that’s for you to decide. But what I will tell you is this strategy is ideal if you do have an interest in trading a scary and risky stock like FB.
How to trade FB while removing “having your face ripped off” risk from the equation:
The options strategy is called a vertical spread. The structure involves buying one option contract at a certain strike price while selling another one against it at a different strike price. Both options are executed on a 1 to 1 ratio and in the same expiration date. They are also of the same type, meaning both are Calls or both are Puts.
That’s your vertical spread.
If you’re bullish, you’ll buy a lower strike Call option and sell a higher strike Call option against it. The cost of the spread is your total risk.
If you’re bearish, you’ll buy a higher strike Put option and sell a lower strike Put option against it. Again, the cost of the spread is your total risk.
Ideally, you’ll want the price action to approach or go beyond the short strike option which will realize your maximum profit potential.
By offsetting the purchase of one option by the sale of another, it creates several distinct benefits, especially in stocks like FB.
First, options are expensive in FB. The implied volatility, which is a key component to the price of an option, is currently very high in Facebook. So by selling an option against the one you buy, which creates the spread, offsets a great deal of the elevated premium in the options.
Second, the position is fully hedged and cost efficient. The idea is to lay out far less capital while never having to buy (bullish) or sell short (bearish) any of the underlying shares of stock. In essence, the strategy will give you a directional exposure without having to trade directly in the stock. The result is a reduction of cost while clearly defining your risk to the purchase price of the vertical spread.
We’ll structure two vertical spread examples in FB, one bullish and one bearish, to help you visualize the strategy and see how it can be used for both directions.
In both examples, we’re going to focus on July expiration which is about 50 days from now. July expiration should allow ample time for either thesis to play out and may capture Facebook’s first earnings report since going public—an event that will no doubt drive price action in a big way.
In both examples, the vertical spreads were priced off of yesterday’s closing price in FB of 28.19.
The bullish vertical spread example:
Referencing the chart, the green area highlights my bull Call vertical spread structure. I’ve constructed the FB July 29/33 Call spread that cost 1.35. The spread consists of buying one July 29 Call and selling one July 33 call. Every spread risks $135. The goal is to have FB’s stock price at or above the 33 strike by July expiration. At that point, the position would expand to its maximum profit potential of $265, nearly a 200% return on your investment.
The bearish vertical spread example:
Referencing the chart again, the red area highlights my bear Put vertical spread structure. Instead of shorting FB stock which can be dangerous and capital intensive, I’ve constructed the FB July 28/25 Put spread that cost 1.25 instead. My bearish trade risks $125 per spread. The goal this time is to have FB’s stock at or below the 25 strike by July expiration. At that point, the position would expand to its maximum profit potential of $175, or a 140% return on your investment.
The vertical spread strategy can be an ideal alternative to trading directly in the underlying stock, especially if you’re considering trading a scary, volatile and unpredictable stock like Facebook currently is behaving.
It’s cost effective while creating a risk parameter that is clearly defined by the purchase price and the number of spreads you transact.
And most of all, this strategy can be very empowering because if you don’t want to trade FB, it’s not going to be because it’s too risky and you can’t. Rather it’s now going to be because you simply choose not to.
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