By: John J. Critchley, Jr.
Facebook (NASDAQ:FB) options started trading today on all major exchanges a mere week and a half after the much hyped IPO was listed ignominiously on the Nasdaq exchange.
The severely maligned IPO process and subsequent Nasdaq listing debacle has led to more heightened interest in the social media giant. With this increased scrutiny comes volatility and with volatility comes trading opportunities.
The first day of trading has been illuminating and interesting in FB options.
Here is a snapshot of what we have observed so far today:
1) Implied volatility in the options is around 58.5%. Many market participants had made estimates that initial implied volatility would be trading anywhere from the mid 50s to high 80s. The implied volatility is definitely trading at the low end of the estimated range. This is quite surprising and may create an opportunity to pick up some "cheap" options.
2) Volatility skew is only mildly steep. Many market participants expected there to be a severe volatility skew and this expectation has so far not materialized. The volatility skew between the out-of-the-money puts versus calls has been generally muted which may present a compelling opportunity to buy some "cheap" protection.
What Is Volatility Skew?
This means quite simply that the out-of-the-money (OTM) puts trade at a higher implied volatility than at-the-money (ATM) puts and OTM calls. Normally as a stock rises a common strategy that is extremely popular with institutions and public customer is to overwrite (sell) the options against existing underlying equity positions. The basic theory of supply and demand kicks in and drives the prices lower as the liquidity providers lower the price of the options as the supply increases.
Another common query is: Why is the volatility in the out-of-the-money (OTM) puts normally so much higher than the OTM calls? Part of the explanation was described above, but there are other explanations as well. In general, large violent moves in stocks have a tendency to be downward in nature. Whereas, institutions and public customers have a tendency to sell OTM calls in order to bolster return, they will buy puts to protect themselves against unexpected large downward movements in the underlying.
here are of course, instances (takeover rumors, extraordinary upside run-ups in an underlying, development of a breakthrough product like a new drug etc.) where the OTM calls will carry a higher volatility but, in general the fear of the unknown on the downside is much greater. Investors and traders are much more willing to pay a higher premium for insurance protection, which means implied volatility on OTM puts will normally trade at a higher level than the at-the- money (ATM) puts. If the sentiment in Facebook ever turns positive and there is a sharp spike in the underlying like we witnessed in AAPL a few months ago, expect the volatility skew to reverse itself and become a smile. A smile occurs when the OTM calls trade at a premium to the OTM puts. This is very rare, but can happen.
Here is a chart of the front month skew in $FB options:
3) Option volume is very robust. The pre IPO retail investor stock mania has bled over in to the trading of Facebook options. As of mid day, Tuesday May 28th, there have been over 210k options traded and there is a chance that the Facebook options may break the options record for a debut listing. Interestingly, 48% of the put trades have occurred on the offer which is indicative of aggressive retail order flow. However, the put/call ratio is 1.5:1, which is not very high and not bearish in any sense. The option marketplace seems to be sending mixed signals as far as interpreting order flow bias.
4) The put-call parity in the options is fairly priced. There was widespread concern that due to the fact quite a few people think the stock is overvalued and want to short the stock that the stock would be impossible to borrow. This turned out not to be the case and any buyer of puts today received a fair price when compared to the price of comparable call strikes.
Why care about the cost of borrowing Facebook? The simple answer is that it will get priced into the options in the form of reversals and conversions and affect the pricing of synthetic options. The increased borrowing costs could have driven up the prices of the puts and also made option conversion prices shoot higher.
5) The option markets are reasonably narrow and appear to be quite fairly priced. The main obligation for market makers is to provide an orderly and liquid marketplace. The option markets in Facebook today were quite liquid and narrow. It looks like the option market makers did a much better job in creating a fair marketplace than their counterparts that traded the underlying in the first few days over at the Nasdaq.
Let's see what tomorrow brings.
We are not liable for any trading decisions made by any reader. No advice is given or implied. The information offered in this article is for demonstration purposes only and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options.
Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.