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Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
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  • Twitter Stock Options: What To Expect 0 comments
    Nov 14, 2013 8:32 PM | about stocks: TWTR, FB, GOOG, LNKD

    Twitter Stock Options: What to Expect by Market Authority

    I've written a few missives about how the Twitter (NYSE:TWTR) IPO was handled by the Wall Street cartel, today I'd like to provide insight on what to expect from the options market once they open for trading tomorrow, Friday November 15.

    First, take a look at how TWTR fared over the last 5 days.

    Twitter Stock Chart

    TWTR has traded in a very wide range (25%) from $50 to $39.40 since it opened for trading on Nov 8th. This is typical of hot IPO's as the range of expectations by buyers and sellers is very wide. Nobody can say for certain whether TWTR will be at $20, $40, $60, or even $80 in a few months from now, and this initial uncertainty causes wild gyrations in the stock price.

    Due to the volatile intraday movements in the stock, the options are going to contain heavy premium. Keep this in mind if you're planning on outright purchases of puts or calls- the volatile movements in the stock price are already "implied" in the put and call prices.

    On top of this, there's something else you need to be aware of. Although TWTR is now a $24bln company, they only floated 10% of the company to the public, or 70mm shares. The rest is still held by insiders and VC's. This small float will have a large effect on the option premiums.

    Let me explain:

    The price of an option is a reflection on the behavior of the underlying stock.

    And in order for you to short a stock (ie bet that the price will go down), you have to be able to borrow it from someone. When you borrow a stock, you have to pay the owner of that stock an interest rate that's set by the supply and demand in the borrow market.

    For instance, if something is easy to borrow (like SPY shares), you'd pay an annualized interest rate close to 0%.

    However, for heavily shorted companies (like NFLX and HLF)- the borrow is much higher - sometimes as high as 100% a year!

    In TWTR's case, if you combine the small float and the large number of investors that want to short this stock, you are looking at a current borrow rate of 15-20%.

    So, if you were to borrow TWTR and short it at $40/ share, if you add in the cost of borrowing the stock, the price you are really selling at 1-year out is $32/ share. If you were to hold the stock for a year at a 20% borrow, TWTR would have to be below $32 (a 20% drop) for you to break-even on your short.

    Now, there are a lot of variables that can change. First, the borrow rate will come down at some point if the stock falls and shorts cover for a gain OR if the stock rips higher and shorts get squeezed for a loss. Also, your holding period may not be a year.

    Now, here's the part why borrow rates have a huge impact on options prices…

    Options don't appear out of thin air. In order for you to buy a put or a call, you have to have someone willing to take the other side of the trade. Think of an option like an insurance policy. If you want to buy an insurance policy, you need to have someone write that policy to you on the other end. For new issues, like TWTR, most of the trades are handled on the floor of the CBOE and the AMEX by market makers. These guys are very smart traders, and they don't like losing money. Options market makers are some of the best traders, who know how to make tons of money without taking very much risk. I personally know a guy who made $60mm in the mid-90s trading AOL options. And this was on trading customer flows with a hedged book!

    If you are to buy a put on TWTR, the person selling it to you needs to offset that risk by shorting the stock. Since the stock borrow is 20%, the seller of the option is going to require extra premium from the buyer to offset the cost of borrowing the stock.

    And here's the danger- even if you bought puts and correctly guessed downward direction, the move lower may cause short sellers to cover the stock. As the shorts cover, the borrow becomes cheaper and the implied premium in the option compresses. Even though you guessed the direction correctly, you may still lose money because you paid too much for the option when the stock was hard to borrow.

    My advice is to use spread trades (even 1×2's) where you are offsetting your high premium costs by selling other strikes. Or, just avoid this trade altogether if you don't understand how options are priced!

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    Stocks: TWTR, FB, GOOG, LNKD
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