In January, I proposed a range strategy using options on Facebook (NASDAQ:FB). It was expected to perform at its best as long as shares remained between $120 and $145 on the approaching expiration date, April 21. The strategy has worked out well, earning close to the maximum potential gain at the end of day on April 19. In this article, I would like to discuss the lessons learned during the preceding months. I will explain how the option market dislocation observed in January was peculiar compared to conditions seen most of the time. Finally, I will consider the question of whether the strategy should be re-initiated afresh, starting today.
Shares staying inside the inner range = profit
As a reminder, back when shares were at $132.08 on January 27, the idea involved selling out-of-the-money $145 calls and $120 puts. To limit the downside risk, it required buying still further out-of-the-money $150 calls and $115 puts. This is what happened to each of the four options since then:
- $120 puts, assumed to have been sold at January 27, 2017, closing bid price of $2.06 (the ask being at $2.12), depreciated to (bid-ask) $0.00-0.02 as of April 19 close. This is unsurprising, as $120 put strike is now far out of the money. The gain at current mid-market amounts to $2.05 per underlying share.
- $115 puts bought at the asking price of $1.28 (bid: $1.23) were recently quoted at $0.00-0.01. The mid-market loss of $1.28 represents the necessary evil of having to limit the risk in the event of a large drop in the share price. It is, however, more than offset by the gain on the $120 put position.
- $145 calls sold at the bid of $1.85 (ask: $1.90) dropped to $0.04-0.05, resulting in a profit of $1.80 per underlying share.
- The profit on $145 calls is more than enough to cover the loss of $1.12 on $150 calls bought at the asking price of $1.12 (bid: $1.07). They were recently seen at $0.00-0.01.
The position size for each option is meant to be the same. It is assumed to be 20 contracts to make the maximum loss in case of a large share price move in either direction equal to around $10,000. This amount is exclusive of the initial proceeds of $3,020. The difference, at $6,980, is the capital that would have had to be committed to the trade on January 27. The four positions valued at $2,920 at April 19 close have earned nearly the full amount of the maximum potential gain of $3,020, representing a 42% absolute return, or 186% annualized.
The following chart shows how the current trade value came to be. Note that the drop below zero out of the starting gate represents the payment of one half of the bid-ask spread, as sales were assumed to have been done at the bid while buys were at the asking price.
Chart 1: The mark-to-market value of the strategy in FB options proposed as of January 27, 2017, market close. The assumed position size is 20 contracts of each of the four options.
Source: Author's analysis
Key risk factors
It is now useful to ponder why the trade worked. Let's consider the risk factors. As this is an options strategy, the question is not whether shares are under- or over-valued. Rather, our concern is with news affecting the company's fundamentals and with factors that could alter the demand for shares. An earnings release can sometimes result in a drastic and nearly instantaneous price move. A competitor doing an IPO could cause a sudden repricing of fundamental metrics underlying valuation. If successful, it could also result in a slow drift of long-term investors buying into the upstart, causing a sustained drain on Facebook's share price.
A one-time risk: the earnings announcement on February 1 was a non-event
An earnings report was to be released soon after the idea was presented. The possibility of an outsized market reaction following the news release is the first, and most obvious, source of risk in this strategy. Indeed, February 1 saw the highest daily return of +2.2%, as well as the greatest absolute daily return for the entire period from the day the idea was described and until present. As a testament to the quality of the idea, this move alone was far too small relative to about +/-10% returns relative to the share price of $132.08 on January 27. Such returns would have to occur to reach the inner strikes of $120 and $145, whereupon the profitability of the trade would begin to suffer.
The company has a track record of outperforming consensus estimates. Yet, no firm can outperform expectations forever. The February 1 announcement of beating both earnings and revenue estimates had a short-lived positive effect: shares gave back almost the entire February 1 gain the very next day, losing 1.8% on February 2. It would appear that the very high growth expectations make the risk of an earnings release biased to the downside. While an earnings beat did nothing, coming in line or falling short of estimates (however atypical this would be) could precipitate a sizable drop in the share price.
Both one-time and ongoing risk: Facebook has defended its moat in the face of Snap IPO
Snap Inc. (NYSE:SNAP) IPO on March 2 gave rise to a previously unseen risk to Facebook's shares. Snap, oddly enough, presents itself as "a camera company"). Being a social network, however, it had the potential to become a growing competitor to Facebook. Investors driven by the idea of diversification within a sector could have chosen to reallocate some of their funds out of Facebook and into Snap shares.
Facebook's valuation could also have been impacted. A rare example of a publicly traded company that could be an apples-to-apples comparison to Facebook, Snap could have caused the market to rethink the fundamental metrics such as the enterprise value per monthly active user.
None of this has happened. Facebook has shown the ability to copy Snapchat's features. Its scale, as measured by the number of daily active users, has been growing and exceeded Snapchat's. The picture of Instagram becoming a slowly deflating balloon could not be further from reality. The takeaway is that the negative pressure on Facebook shares the initial public offering of Snap could have exerted is just not there.
A stock that rises 0.11% every day has a zero volatility
What if shares went straight up from the day the idea was proposed, rising by the same percentage every day? Mathematically, the realized volatility would be zero. Indeed, a big part of the motivation for the original idea was the belief that the stock would be less volatile than implied by options' market prices. Modeled option prices are sensitive to volatility; the sort of steady climb Facebook experienced since January is both statistically unlikely and unanticipated by option pricing models.
The sold options, $120 puts and $145 calls, were sold at annualized implied volatility values of 26.8% and 23.5%, respectively. The realized volatility of the firm's shares from the inception date in January until present was much lower at only 11.3%. This corroborates my original belief that the market overvalued Facebook's volatility in January. The proposed strategy is short volatility. So, it might appear that a profitable outcome should have been assured. This, however, is not the case: up until now, the position retains a significant lottery ticket-like risk due to proximity of $145 strike level.
A long-term trend is a risk factor that actually materialized
Note how shares have been marching up from January until late March, reaching successive all-time highs.
Chart 2: Daily closing prices of FB shares, starting from January 27, 2017
On average, the closing price rose by 0.11% daily. As a result of this statistically unlikely climb, shares came rather close to the critical level of $145, where the payoff would rapidly start turning negative.
Why not do this trade again?
This type of strategy can be contemplated at any time. However, its attractiveness will vary. I find it helpful to measure it via the "expected return", taken to mean that the excess of the initial proceeds realized at market prices, over and above the initial proceeds, computed using a somewhat realistic model is earned during the time between the commencement of the strategy and the expiration date of all options.
Back in January, the expected annualized return was estimated at 38% "if trades were done at the bid or ask side of the market for each option, as appropriate". To evaluate the opportunity found in January, let's try to construct a similar strategy as of today.
At the time, April 2017 options had between 2.5 and 3 months left till expiration. Currently, there is no listed expiration that would come close to matching this. The closest choices are June 16 with under two months left, and September 15 with over 4.5 months left. Let's consider both. As for strikes, given the share price of $142.32 on April 19, the strike choices most similar to the January idea would involve selling $130 puts and $155 calls, and buying $125 puts and $160 calls.
If such a strategy were implemented as of April 19 close using June options, I see a zero expected return. The estimate is under the same assumption as the 38% annualized expected return for the January idea: buys at the asking prices and sells at the bid.
Conversely, if such a strategy were implemented as of April 19 close using September options, I estimate a 17% annualized return.
No model is ever perfect. It would make sense to aim for the biggest model-predicted edge that can be realistically obtained. The conclusion here is that the strategy looked much better in January when it was proposed than similarly constructed strategies appear today. The market will always be there. On balance, I believe that if one looks at Facebook specifically, better opportunities in range strategies are to be found in the future than are available at the moment.
My analysis of the market in options on Facebook in January yielded the belief that April options were overpriced. This view was supported by both shares and options since then. The idea of selling equal quantities of $120 puts and $145 calls and buying $115 puts and $150 calls yielded the absolute return of 42% (186% annualized) by April 19 market close.
I foresaw little impact from Facebook's Q4 2016 earnings announcement. This was corroborated by the pattern in daily returns around February 1. Another potential source of volatility, the Snap IPO, failed to make a dent in Facebook's moat. Still, it is not as if the strategy's progress from its commencement to the present moment was all smooth sailing. Statistically, it is rare for shares of any company to keep climbing up as steadily as Facebook stock did until late March. Low realized volatility notwithstanding, this pushed shares towards $145, a level where sold $145 calls would start to affect its value at expiration. It would probably be a good idea to repurchase these calls, offered at only 5 cents per underlying share on April 19, to eliminate the risk to the rally Facebook might experience in the last two days before expiration.
January was a particularly good time to propose this idea. Its expected return, seen at 38% per annum at the time, is much better than a 17% annualized return estimated for a similar strategy as of April 19, using September options. For this reason, I would not re-initiate a similar strategy right away. It would be better to wait for an opportunity similar to that seen in January to appear again.
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Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
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.