Facebook's Volatility: A Blessing For Investors

| About: Facebook (FB)

Summary

Facebook's stock always drops, not because it's a bad company (it's not!), but because it's highly volatile.

In a previous article, I mentioned selling Facebook one month before earnings to avoid the volatility risk, but many FB holders refuse to sell, requiring another method of mitigating risk.

Writing covered calls after volatility strikes can bring in a significant amount of income with FB.

Most covered call writers make the mistake of setting the strike price too high, which eats into your profits; I explain this misconception.

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Facebook (NASDAQ:FB) meets my criteria for a monopoly. Although other social media businesses pop up frequently, none has the international cover and advertising potential FB has (when I was a marketer, I would tell my clients, "If your ad doesn't work on Facebook, it won't work anywhere). But most importantly, Facebook monopolizes the small market of social media addicts, making the company defensible in the long term from startups.

Despite its sound business model, Facebook makes its investors wake up in the occasional cold sweat due to its high volatility. In the past month alone, we've seen FB jump from $95 to $115, and then to $100. Now it's back at nearly $110 - all in under 30 days.

For day traders such as myself, FB is almost an ideal stock for daily income. But for investors, the volatility is a nightmare. In this article, I offer a new viewpoint: That FB's volatility can be a blessing.

Volatility as a Blessing

The $20 monthly swings are compartmentalized of $5 daily swings. When you put it in terms of percentages, you're looking at 5% swings in your investment nearly every day. But volatility does one thing for long-term FB holders: It makes options more expensive.

Compared to other tech stocks, such as Amazon (NASDAQ:AMZN) or Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), FB is relatively cheap. Yet, the volatility is high enough to price the options at high premiums. Investors can leverage this volatility to sell covered calls, yielding a profit that acts much like a dividend.

If you are holding Facebook and have never run a covered call, I recommend you try FB for your first. You will be amazed to find yourself hoping for a daily dip in FB - or at least not dreading it. I've done the hard work for you: Finding the right covered call strategy.

A quick note on how we make money from covered calls: We want to find a call option to sell at a high price, but that will also decay in price quickly. Much like sly used car salesmen, our goal is to sell something that will depreciate.

Because we are banking on FB's volatility, we are most interested in the option Greek known as vega. Vega represents the impact on the price of the call option due to an increase in volatility. We are short on vega when we sell a covered call and therefore want a strongly negative vega.

As for the option itself, other sources of income come from theta decay and being short on delta. These mean, respectively, that we want time to eat away at the value of the option and that we want the option to quickly lose value if and when FB drops in its stock price. Being long theta, short delta, and short vega give us three ways to profit:

  1. If FB drops, we make money off the option due to short delta.
  2. If Facebook trends sideways, we make money off the option due to long theta.
  3. If it becomes less volatile, we make money off the option due to short vega.

But because we hold the stock, we are actually long delta, and profit overall when it rises (we are long FB because we believe it will rise, after all). The stock is 100 delta and the written call is -X delta. Adding them together we get (100 - X) delta, which will be positive, allowing us to profit on the covered call position up to a certain point, which is usually well past the strike price of the written call.

The Strategy

So how do we play this strategy? Remember, we profit from one or a combination of the following three ways:

  1. FB rises
  2. FB trends sideways
  3. FB decreases in volatility

We also want to maximize the price of the sold call at the time of writing the call. This means we want a lower strike price, a higher volatility, and a longer expiration date. But these factors are in direct conflict with the factors we want when we hold the position.

The ultimate strategy thus finds a roundabout way to getting the best of both worlds. I use a service that calculates the expected profit of each strategy. I'll show you the results for FB covered calls in a bit.

But, as a rule of thumb, here is my suggestion for FB specifically:

  1. Wait for a highly volatile day.
  2. Note the high for that day - round up to the nearest $5 (e.g., if FB's high today is 107, round to 110).
  3. List all the call options at that strike price and choose the one with the highest vega/theta ratio, ignoring sign.

Alternatively, if this is too much work, simply take the option with the highest vega (in magnitude, that is):

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Why do we want a high vega? Because, if we opened a covered call on a highly volatile day, we sold it at a price higher than normal. We can also reasonably suspect that volatility will subside*, thereby quickly eating the value of the sold call, which is what we want.

I usually would not recommend basing a written call on vega, but it makes sense for holders of Facebook. As an investor, you want to mitigate the volatility. In this way, we are using FB's volatility in our favor by selling at high premiums.

As promised, here are the results of the program I use for arranging covered calls by expected profit:

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You will see that all the top covered call strategies have high vega values, further validating the high vega covered call strategy for FB.

A caveat specifically for the company: In all the above cases, I would shrink the expiration down to one month out at the most. The reason is that FB is a strong company that can easily move into new territory after a news event or earnings. It's better to sell the weeklies or closest month and roll the strategy over at the cost of an extra $10 commission than it is to see FB climb into the mid-100s while you have a July call out there in someone's hands just for some extra extrinsic value in the option.

Possible Outcomes and Risks

The number one mistake I see on Seeking Alpha of contributors recommending covered calls is setting the covered call strike prices too high. You'll notice the covered call strike prices in the charts above are just over the current value. Amateur option sellers are usually overly careful with their strike prices, choosing strikes that almost certainly won't be touched by the stock.

The logic behind this risk-aversion strategy might be sound if your biggest fear is being exercised. But being exercised is quite rare. I make one or two options trades per day and only recall being exercised once - and that was a special case in which the buyer of my written call exercised the option prior to the stock's ex-dividend date to gain the dividends of the underlying.

But let's say that you cannot risk being exercised, perhaps for tax reasons. If that's the case, then by all means set a very high strike price. Or just avoid covered calls.

For the rest of us who are investing primarily to maximize wealth, we should not fear the FB touching a sold call's strike price. First, the myth that you stop earning money on the stock when the stock price has touched the call's strike price is just that - a myth. Your held FB stock has 100 delta, whereas your sold option will have a delta of 50.

This means that you can expect to be up $50 for a dollar move over the strike price. So, if FB is trading at $111 and your option's strike price is 110, you are up $50 overall. The strike price does not cap your earnings on the stock.

Second, lower strike prices give higher premiums. Because we are not going to be running long-expiration date call options, we should pump up the value of the option via closer strike prices. As stated previously, low strike prices offer little downside but allow you to gain more money on your written calls.

When the stock drops, as it inevitably does due to volatility alone, you can easily buy back the written option at a lower value and take your profit practically any day of the week. I recommend doing so on or after a day with a down area gap.

On the volatility note, astute readers would have noticed a * in the section above. I should point out that volatility is not always random and independent; high volatility can beget high volatility. So ensure that you're writing the option on a randomly high volatility rather than a day that falls in a trend of increasingly volatile days, which could raise the value of the written option, making it harder for you to buy it back.

So to recap:

  1. Write a written call with a low strike price (slightly above FB's current price) and short expiration date (no more than a month) on a high volatility day.
  2. Now you have two options: Let the option expire or buy it back and repeat.

If you let the option expire, the option should be out of the money. If the option is out of the money, you keep the entire premium for which you sold it. If not, you will have to buy it back - usually at a lower price, still allowing a profit.

The alternative is to watch FB for a dip on a low volatility. On that dip, buy back the call option at a nice profit. Rinse and repeat.

The best-case scenario is you make 3% to 6% of your investment per expired written call. The second best case scenario is you make roughly 2% of your investment each time you buy back call options on dips.

The worst-0ase scenario is that you are exercised. This is rare but possible. The second worst-case scenario is that you have to sell your FB stock and buy back the call to realize a profit; this will only occur if the option goes significantly in the money.

Conclusion

So there you have it: A strategy that turns the dreaded volatility of FB into a bonus. This strategy fits nicely with the previous one I wrote about: Avoiding FB before earnings. I found that many investors want to mitigate the pre-earnings volatility but are not willing to sell FB prior to earnings.

Hence the above strategy. You can hold FB during earnings season and still profit. Of course, if you expect a bullish earnings report, ensure you buy the call option back before the earnings report is released; simply begin this strategy one month prior to earnings, ending it the day before.

I hope this has answered the reader who asked about holding FB prior to earnings. If you have any other questions regarding this stock or strategy, make sure you ask in the comments section below. Thanks!

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.