Facebook: Shorting Through Options

By: John J. Critchley, Jr.

The Facebook (FB) IPO came in like a lion and is going forward like a lamb. Do you want to short the most over-hyped IPO of all time, but can't borrow the stock? What's the investing public to do? Use options.

On May 29th, the options exchanges will offer FB options. In the past, it might be months before a hot IPO has options listed on them. Nowadays, in the 24/7 interconnected investing world of today, there is no patience; no waiting for the "right time." When these options become eligible for listing in a little over a week, they will trade.

Many option market makers will tell you that the longer wait in the past was absolutely necessary as options pricing is fundamentally based of implied volatility. Implied volatility is based off the historical (real) volatility of the underlying and such a short time frame makes it quite difficult to accurately and fairly price the options.

This pricing difficulty consequentially leads to wider markets and potentially less favorable fills for the retail trader. As long as the retail customer is aware of this "pricing" dilemma and accepts the possibility of a less than favorable fill, then the trading in Facebook options presents a compelling way for the retail to express its fundamental view on the biggest internet IPO in history.

Facebook will be nearly impossible to borrow in the near future. When the time comes that some shares do become available to borrow, the scarcity of these shares will cause the cost to borrow to rise to an astronomical level.

For an example of a hard to borrow stock in today's marketplace, one has to look no further than another social media high flyer, LinkedIn (LKND). The float in LKND was initially under 10 million shares. At the same time, there were quite a few investors that believed the stock was massively overpriced, and thereby want to be short the underlying. The combination of a low float with a perceived overvalued stock resulted in an underlying that was extremely hard to borrow and therefore short.

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.

What are Synthetic options?

A synthetic short is a combination of a short call and long put. A synthetic long position is a combination of a long call and short put. The basic formula is: Call minus (-) Put=Underlying Stock Price minus (-) Strike Price plus (+) Cost of Carry. This simple formula lets anyone create synthetic long or short stock out of just puts and calls.

Why Options?

You can synthetically sell 1,000 shares of Facebook by selling 10 calls and buying 10 puts of the same strike and expiration. When interest rates are so low, the price of selling the calls minus the price of buying the puts, plus the strike price equals the synthetic price you have sold the underlying.

Sounds good. But hold on a second, the rate to borrow (cost of carry) of Facebook will not be low. To the contrary, it will be sky high. After LKND was listed and was so hard to borrow, the cost of carry for the underlying reached an absurd 50%. The consequence of this high rate is that the retail customer will pay more for the puts and receive less premium for the calls.

If you want to short Facebook and cannot borrow the stock, consider using the synthetic short underlying strategy described above. But be warned - the put prices will be extremely expensive relative to the call prices.

Let's see what happens next week. Stay tuned ...

Notes: Prices quoted where the prices at time of submission and do not reflect current market prices.

Disclaimer

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.

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