Facebook (FB) has been as exciting a stock trade as watching a Hollywood blockbuster movie or maybe more accurately a theme-park attraction.
The Market Is Listening! (illustration by Chloe Waters)
Since Facebook went public on May 8, 2012, the stock has been all over the place. From the brief rally after the IPO to the plunge that happened shortly after, the stock has been telling a story. It's a story I'm going to re-tell in this article.
Afterwards, I'll present my analysis of the stock including its current open interest on the October, November and December options contracts.
The IPO - The Beginning (May 8, 2012)
The rocky IPO started off with bad assumptions. It was overpriced based by almost any valuation. In order to buy Facebook you had to believe in the story. You had to be able to see where it was going. Some people did.
Obviously Mark Zuckerberg believed in his baby. Then we have the dramatic entrance by Sean Parker of Napster fame as a key player. Sean recognized the value immediately and in an epic move he made sure he was a part of the Facebook IPO and can even be given significant credit for making it happen.
The underwriters could see it. Tech savvy investors might have been able to see it as well but the market as a whole wasn't having it.
Investor's hadn't forgotten the lessons learned by MySpace. They knew how fickle social users could be and how fleeting their loyalty. They didn't buy the value of users without a matching revenue stream. Facebook was saying they could monetize their users but until that happened, the market just didn't believe the story.
It also didn't help that the company's founder had a reputation for being opportunistic at the expense of others. Investor's still hadn't forgotten the famous lawsuit with the Winklevoss twins, and the lawsuit with co-founder Eduardo Saverin even though those had happened years before.
And so after a brief rally, it was a big IPO after all, the stock plunged leaving our protagonist to struggle to recover investor confidence. Just to add a twist to the plot, technical issues by NASDAQ on the launch day made this a very harrowing ordeal for many investors leading to an SEC investigation that resulted in a ten million dollar fine against NASDAQ.
Just before the Q2 2012 earnings, the stock was trading at $26.85.
Q2 2012 - A Chance For Redemption (link)
By the time the Q2 2012 earnings came around, investors had been burned and were massively disappointed in the stock and the company. But a lot of them were still exposed having bought at the IPO and were looking for a way out. Underwriters, institutional and even mom and pop investors had gotten on board and still needed a happy end to the story.
The $38 price point was the magic number that investors needed the stock at to see all their hopes and dreams fulfilled. The Q2 became the point that we all hoped would be the new beginning of the story.
In anticipation of the earnings, the stock rallied and everyone held their breath. But hope was shattered when Facebook came out with a seven hundred and forty-three million dollar loss.
The one thing that would become very significant and that I want to highlight at this point in the story is when Mark Zuckerberg announced during the earnings conference call that the company's priorities were "mobile, platform and social ads".
Mobile would be critical both for retention and monetization. Unlike other companies that recognize trends after they start, the Facebook executives saw the trend coming and were ready for it.
Unfortunately, the market was focused on the performance and punished the company with another sell-off dropping the stock back into the teens from its pre-earnings rally in the low twenties.
This is where I jumped onboard. I wasn't able to participate in the IPO launch and jumping in with the rest of the public after an IPO is usually not a good idea. I liked the stock and would have been a part of the drama if I'd had the chance but in this case luck was on my side.
After the plunge, I had analyzed Facebook from as many angles as possible. I liked the team. The architecture was solid and relatively transparent. The product worked for everyone I knew; it was the platform to keep in touch with friends and family. And Mark Zuckerberg was unbelievably as persistent as he is technically talented.
I decided I liked the story and I was going to buy in at the point where the rest of the market had already decided that Facebook was a bust. At around $19 a share, I opened long positions in Facebook for both my retirement accounts and my trading account.
When Q3 2012 earnings rolled around, the stock was trading at $19.50.
Q3 2012 - A Light At The End of the Tunnel (link)
After hours on October 23, 2013 the Q3 earnings were to be announced, investors were exhausted and looking for other stocks with which to fall in love. The stock went into the Q3 earnings without the pre-earnings rally that typically indicated the anticipation of good news.
When Facebook announced that they were in the black with earnings of $377 million, the market reacted by pushing the stock up to $23.23 the day after the announcement. But whether it was profit taking or a general lack of faith, the stock drifted back to $19.21 over the month following the announcement.
But sentiment started to change and the stock price started a rally that would bring it up into the low thirties by the time of the Q4 earnings announcement.
While I was showing a nice profit, I decided to keep my positions open because I still had faith. I believed the story they were telling.
Oh yeah, and Facebook still kept doggedly hammering at the "mobile" theme citing substantial growth in mobile users over desktop.
Going into the Q4 2012 earnings announcement the stock was trading at $31.24.
Q4 2012 - Maybe That Light Is The Train In Front of Us (link)
This is the point in the story where you thought things had turned around for the main character but all at once, he loses his job, the bank repossesses his car and his wife leaves him taking his dog with her and someone writes a country song about it all.
Mark Zuckerberg announced again that Facebook was a mobile company. He highlighted the dominance of the Facebook mobile app on the different platforms and even pointed out that the second largest mobile app was Instagram, an acquisition Facebook had made earlier that year.
Even though Facebook showed earnings growth from Q3, rising expenses, lowered expectations for future revenue growth and ratings cuts by analysts took the wind out of the rally causing investors to either take profits if they were lucky and write off losses if they weren't.
For me, the story hadn't changed and neither had my reasons for being in the stock but while I still believed in it, I wanted income from my positions so I started writing covered calls.
Facebook was trading at $31.24 the day before their Q1 2013 earnings announcement.
Q1 2013 - It Will Work, We Promise! (link)
By this time, all the supporting characters in the story have abandoned our protagonist and you have a montage with a popular theme song in the background showing the main character struggling to pull things back together while at the same time doing some dramatic introspection and re-affirmation.
In some stories, this causes the protagonist to make the changes that were necessary to fix the things that were broken. In the Facebook story, the main character just had to not give up before reaching the point where the promised results would be visible and obvious to the other characters.
And, of course, that's exactly what Facebook did in spite of the lack of faith by the majority of the market. Even with the odds seemingly stacked against them due earnings misses in general but specifically by major tech giants such as Google (GOOG) and Microsoft (MSFT) all indicated that we've might be kidding ourselves about the state of the economy. Add in talk of winding down QE3 and you have a constant barrage of bad news that were shaking investor confidence.
The market had completely given up on Facebook by this point and were no longer even paying attention. In their collective minds, Facebook hadn't delivered and it was time to find the next best thing.
Me? I was still working my covered calls.
Going into Q2 2013 earnings, Facebook was trading at $26.51.
Q2 2013 - Wait a minute!? What just happened?! (link)
Then we hit the pivotal point in the story where the efforts of the main character pay off.
Facebook announced earnings of $1.813 billion over analyst's expectations of $1.62 billion or $0.19/share over $0.14/share. The market was caught off guard. With this announcement, the market as a whole and institutional investors in particular seemed to have lost all doubt about whether Facebook could deliver on its promises.
The stock shot back up to the $38 level ranging between $38 and $40 briefly but stalled for a bit dropping back down to $37 before its most recent rally breaking through resistance to a close of $40.55 on August 23, 2013.
Institutional investors finally decided that Facebook was a serious stock and needed to be added to their portfolios. The Seeking Alpha article "Big Money Is Pouring Into Facebook From All Directions" states that Facebook led the pack on new positions by institutional investors.
And while I believed in Facebook, I had expected this to take longer than it did considering the overwhelming negative sentiment up to this point.
I had to adjust my strategy and roll my options forward to keep from being called out.
The Audience Is Listening
Now that Facebook has the market's attention, what is next.
Facebook still has quite a bit of potential for leveraging its current user base. But they are also continuing to broaden their features. Along with Mobile, they are working on several new offerings that will enhance their monetization of their existing user base as well as create new revenue streams.
They want advertisers to fork over $2 million a day to reach Facebook users with their new Video Ads. The key for success is to do the ads in a way that doesn't alienate users. Something they've done a pretty good job for their current ad offerings.
But, it seems like the market has mostly forgotten about the Ace that Facebook is holding. Recent articles have speculated whether Facebook was losing their younger audience to other products including Twitter and Instagram. Among the two, the biggest perceived drain on their users is Instagram.
But wait? Doesn't Facebook own Instagram? So far, Facebook is allowing Instagram to grow its user-base and is keeping their hands off.
But this is a familiar sounding story. Didn't they do the same thing with the Facebook platform itself? Instagram is a walled garden that the users get to make their very own. And after letting it grow, Facebook can decide in a very careful and considered manner to monetize this product as well.
Trading Facebook Into The Next Act
Since the Q2 2013 earnings, several analysts have upgraded their price targets for Facebook. In one of the more interesting ratings, Tony Wible, of Janney Montgomery Scott, initiated coverage on Facebook at a Buy with a price target of $50. Evercore has an Overweight rating with a price target of $47.
Personally, I like the story so far. The company's performance may not have been in line with the stock price at the IPO but that situation has changed substantially. The company started with some very different assumptions and is continuing to exercise the same caution and consideration moving forward. Just the care it is taking with rolling out its new video ads feature indicates to me that this company and its CEO have a tremendous upside. They will continue to leverage their user base with the primary goal of enhancing the user experience.
Moving forward in the near term, I expect Facebook to continue to range a bit. Short term, I would buy calls on a dip prior to their Q3 earnings to take advantage of expectation. Sell your calls prior to earnings.
The following chart shows the top 10 contracts by open interest for October, November and December. I've also added the weighted average strike price and the put/call ratio or PCR for each contract period. The first thing to notice is that, based on the PCR of 37% for October, the market is clearly bullish on Facebook. Also notice that the weighted average strike price for October is already lagging showing significant upside in these contracts. The stock is moving quicker than the market.
Note that this does mean you must time your entry carefully and with a stock that is rallying like this, finding a good entry can be difficult.
Another approach that might help your timing is to sell naked puts to reduce your cost of acquiring the stock.
With a little research, vertical spreads will work as well but the stock has too much upside potential to put a cap on your profit, in my opinion.