How To Ride Facebook's Wave Of Disappointment

| About: Facebook (FB)

Normally, I'm not a momentum trader. I prefer to pick up shares which are either reviled beyond what the facts make understandable, or to purchase shares that are simply too boring for the masses to care about the cash flow being offered at discount prices.

Additionally, I hate making predictions. So, when my father-in-law and close friends started calling, asking me if I was buying up Facebook (NASDAQ:FB) shares when the IPO was announced, all I had to offer was a terse "no". Still, one particular friend persisted, and asked for a prediction and a recommendation. After much pestering by some, I responded that I would short it.

Did I end up shorting it? Of course not. I filed that little idea away and spent my spare time evaluating Cisco (NASDAQ:CSCO), which led to a trade that so far has netted me an all mighty profit of… $6.00.

Days later, when I heard about the Facebook meltdown, I felt a little left out. Still, I could turn the radio off and ignore the situation. But, when a friend from halfway around the world texted me "I hope you shorted Facebook", I had to face the fact that I had missed quite an opportunity.

The question got me thinking… was it really too late? Two facts stood out in my mind, and lead me to believe perhaps there is more blood to squeeze from this turnip. First, momentum is in favor of a continued Facebook drop. While the random walk theory suggests that the stock is just as likely to go up tomorrow as down, studies support momentum as a real phenomenon in the market. These studies indicate that stocks that have outperformed in the past continue to outperform for 3-12 months. These same studies suggest that underperforming stocks continue to underperform. (For more on the topic, see Jegadeesh and Titman, 1993). Potential causes for momentum, such as recency bias, and herding, deserve their own articles, but the supporting studies, and the fact that Facebook has such a short history, and therefore a defined period of time for the underperformance, gives me some confidence in a future expectation of losses.

Next, a quick look at Facebook's valuation indicates it is still overpriced, with a P/E of 87.11, and a P/FCF of 78.13, there is no reason to suspect an onrush of bargain hunters. A forward P/E of 41.55 leads me to believe analysts would have to be unbelievable pessimistic for the price to be a bargain betting on growing earnings.

Still, I dislike openly short positions, because time tends to be against the trader. Short positions involve borrowing costs, and buying puts require moves in the right direction, in the right timeline, with enough magnitude to prosper.

Anyone reading my articles (1, 2) knows I've been beating the drums on a type of option spread called a diagonal spread. The diagonal puts time more in my favor, since I am gaining both from directional moves, and from the difference of time decay between my two puts.

Here's what I see, looking up the put option chain for FB. A deep in the money $40.00 put for January 2014 costs me $1625.77 after fees. Using the put to hedge my short position, I can sell a July 21, 2012, $25.0 put for $119.23, since my brokerage allows me to sell the spread as one trade. By using the spread, I limit my total loss to $1506.54 (after I sell the short position). I instantly have a 7.33% return for a 39 day investment. In addition, I profit if the stock falls, and I maintain some upside protection. Additionally, I can continue to sell puts on the position if FB does not fall below $25 by July 21, if I believe the stock has more room to fall at that time.


This, of course, is not a riskless trade. The market could turn around and pull FB up, momentum or not. FB could announce developments that rejuvenate its fad-like following. Still, with the premium on a $40 LEAP put being so low, and the premium on the July 21, 2012 put being so high, I feel that this trade has a high probability for profit.

The same trade logic can be applied to LinkedIn (NYSE:LNKD). But with LEAPs on LNKD being less liquid, the trade will be much more costly to open. With a costly opening, I believe the trade is not as attractive as FB.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FB over the next 72 hours.