Facebook: Should You Sell Puts or Buy Calls?

by Nick Atkeson and Andrew Houghton | June 21, 2012 12:25 pm

Facebook: Should You Sell Puts or Buy Calls?

For the first time in 40 years, no companies will go public in June.

IPOs are the lifeblood of investment banks. Fees on IPOs are one of their few revenue areas that haven’t seen significant compression in the past decade.

The Facebook (NASDAQ:FB[1]) flop is being blamed for the absence of IPOs this month. Institutional buyers of IPO stock are “on strike” in the wake of taking a 30%-plus slap on their Facebook shares. Management teams don’t want to be the first to offer their stock at a tremendous discount as a sacrifice to make up for the losses of “Faceplant.”

But there may be more to the lack of IPOs this month. It may have something to do with the fact that no investment bank can predict market conditions day-to-day this month with a straight face as we move from one macro event to the next. It’s nearly impossible to predict the outcomes of Spanish bank bailouts, Greek elections, eurozone rescue measures, FOMC policy action and the Supreme Court “Obamacare” ruling.

A zero IPO month says a lot about the market landscape. It’s just another indicator, along with low trading volumes and a 10-year U.S. Treasury rate of about 1.6%, that conditions are highly unpredictable and potentially volatile. It’s really hard to schedule an IPO during weeks when there’s a chance that the slope of the market could form a sharply acute angle from the x-axis.

At Big Money Options, we initiated an opportunistic Facebook trade, based on the historically bad IPO, that allows us to take advantage of the overall volatility. We sold to open (or shorted) the FB Sept 20 Puts and collected the premium upfront, which is a bullish strategy. Despite FB’s disappointing IPO, our outlook is that it will appreciate over the next few months.

So if you missed the Facebook IPO and would like an opportunity to own FB at a 50% discount to the $38 IPO price and collect money (fully cash-secured) while you wait to see if your order is filled, we recommend shorting the FB Sept 20 Puts at current levels of around 50 cents.

The goal is for FB to increase in value and for the short puts to expire worthless, allowing you to keep all of the premium you collected.

Since selling puts and buying calls are both bullish strategies, many traders wonder what the difference is. Is selling puts more risky?

The risk profile of selling a put versus buying a call is as follows:

If you buy a call, your total potential liability is the amount you paid for the call. For example, each contract represents 100 shares of stock, so if you bought a single call contract for $1, your total liability would be $100.

If you sell a put, your total potential liability is being “put the stock” — forced to buy it. For example, if you sold a single put contract for $1 with a $10 strike price, you would collect $100 in options premium upfront. But if you were eventually put the stock, you would have to buy 100 shares for $10. This would cost you $1,000.

However, at that point you would own the stock, and your loss would be measured by the amount you paid for the stock minus the premium collected minus the amount the stock is trading below your strike (purchase) price.

So it’s really important that when you sell a put, you sell only the number of puts you are comfortable buying in terms of shares of the stock (both the amount of shares and the price of the shares) in the event that you are put the stock. But from our vantage point, we think it’s a safe bet that FB shares will stay above the $20 strike price between now and September expiration.

Endnotes:
  1. FB: http://studio-5.financialcontent.com/investplace/quote?Symbol=FB

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