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What to look for in Facebook options

Chris McKhann (chris.mckhann@optionmonster.com)

I knew that Facebook was in trouble when my mother asked me how she could get some shares. FB touched $45 on its market debut but is now well below its $38 IPO price.

It is early, to be sure, and this disappointing start may have little bearing on the stock's levels in coming years. But in the meantime, Facebook's options should provide some interesting opportunities when they roll out next week.

The options are coming out more quickly than usual because of the huge retail demand. However, it is very likely that the contracts will be both quite expensive and unevenly priced.

Given its brief trading history, the big demand for FB options will be in the puts--both for protection on long shares and for outright bearish bets. This will push the implied volatility of FB options quite high, as will the actual volatility in the stock and its selloff.

On top of that, shares are currently hard to borrow, making it expensive to short the stock. That is pretty typical for an IPO, but it may persist for longer than usual because of the extreme retail interest in Facebook. So when the options come out next Tuesday, May 29, the puts will be far more costly than the calls.

Puts and calls usually will have the same implied volatility for a given strike. This is because if the puts are have a higher implied volatility than the calls, the trader can sell the puts , buy the calls , and sell the stock to lock in an almost riskless profit. But if the stock is expensive to short, there is no way to take advantage of this.

We saw a similar situation with Groupon options when they rolled out in November. The puts had an implied volatility of 100 percent while the corresponding calls had an implied volatility of 50 percent. This reflected the high cost of borrowing the stock.

Typically that situation resolves relatively quickly as shares become available to borrow. But in the case of GRPN, the stock has traded down to $12 as the shares remained expensive to short. We still see puts with implied volatility levels that are twice as high as those of calls.

In theory, the GRPN 12 puts could be sold for $1.40 and the 12 calls bought for $0.75. That would create a synthetic long position at $11.50 with the stock trading at $12.18.

Normally the pros would play that combination and short the stock to collect that $0.68 difference all day long. But that can't be done because of the high cost of shorting the shares.

There will still be ways to take bearish positions, but they will require more advanced strategies. And those with a bullish bias will have some potentially nice trades in short puts or selling those expensive puts and buying calls, which will likely be available for less than buying the stock.

In the case of GRPN, one could buy that combination for $11.50 and be better off than buying the stock. Or traders could simply sell puts, collect the premium, and buy shares for the lower price if assigned.

So while the Facebook options will be a welcome addition, they won't provide a cheap and easy way to protect stock or to take a bearish position. Nevertheless, smart option traders know that there are ways to take advantage of such situations, especially if they are willing to take a contrary position.

(This article appeared in optionMONSTER's What's the Trade? newsletter yesterday.)

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