initial public offerings (IPOs) trading on American exchanges

Sunday, February 5, 2012

Playing Facebook with puts

Facebook announced Wednesday that it expects to sell $5 billion worth of stock on an as yet unidentified exchange. The timing of the IPO isn't yet known, and neither is the ultimate price. But that price is likely to be high enough to keep the total of shares offered relatively low.

Thus, the stock is expected to appear immediately on Wall Street's hard-to-borrow list, making it difficult to short and creating an options-trading opportunity.

The options action will start six days after Facebook starts trading, when industry rules will allow the initial listing of puts and calls on the shares.

after Facebook's stock begins trading, some investors will view it as overpriced and try to bet on its decline. With Facebook shares hard to short, they will instead buy Facebook puts, which would rise in value if the stock were to slide.

On the other hand, anyone who wants to effectively bet that Facebook's stock will climb can sell puts, rather than buy them. This probably is the safer course.

Says a senior trader at a major market-making firm: "There's going to be lovers. There's going to be haters. The haters won't be able to express their view because the float is so small. It's probably going to be a tough borrow."

Puts, of course, give their buyers the right to sell, or "put," shares at a certain price to whoever sold the puts to them. A put's value increases as the price of the associated stock falls.

If lots of investors suddenly want to buy Facebook puts, options dealers could be in trouble if they can't short the stock to hedge those sales. To discourage heavy put buying, the dealers are likely to effectively jack up the puts' implied volatility—the critical part of an option's price—which means that the puts would fetch a premium price and that the stock would have to move very sharply before it overtook the puts' implied volatility premium.

To set the implied volatility of a new stock, options dealers try to determine what existing issues it most resembles.

Dealers are likely to conclude that Facebook's stock is similar to tech stocks with relatively high volatility, like, say, a Zynga (ZNGA), a Google (GOOG) or a (CRM).

Using options to trade an initial public offering, especially one that is as hyped as Facebook's, is not for the meek or the slow. And individuals must realize that they will be placing bets at the same time that extremely sophisticated options market-making firms and their computerized pricing models are trying to determine the real value of Facebook's stock.

But if you are willing to buy Facebook's shares, the bet to make is to sell puts.

If the shares continue to advance, and never fall below your put's strike price, the money received from the sale will be yours to keep. And should the stock slip below the put's strike price, congratulations! You've bought the stock at a discount to what you would have paid if you had purchased it when it debuted.

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