Trading Facebook, After the Crash
A crash is difficult to forecast in advance. That means it can be expensive to make trading decisions expecting a crash. For example, in the internet bubble it was apparent to many investors that a crash would follow the boom. But, many traders were too early and lost money trying to time the crash.
When the crash does occur, many investors expect the market to recover at least some of its losses fairly quickly. This is the “dead cat bounce” pattern that is widely discussed by analysts. And, quite often there is a bounce, in the short term.
This all leads directly to the question of whether or not Facebook Inc. (Nasdaq: FB) is likely to bounce or not.
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Facebook Stumbles and Traders Sell Aggressively
The details of Facebook’s most recent earnings report are widely available. The stock did sell off on the news in afterhours trading. But, the decline in the stock accelerated during the conference call as it became apparent the company would be affected by new privacy rules.
As The Wall Street Journal explained, “Even though Facebook’s stock price had fallen almost 10% in after-hours trading at one point due to a miss on revenue…Chief Executive Mark Zuckerberg opened the call just after 5 p.m. Eastern time by saying the company had“a solid quarter.”
…About 12 minutes into the call, Chief Operating Officer Sheryl Sandberg chimed in, providing her usual litany of examples of how advertisers were adopting its various ad tools.
There were few signs that anything major was amiss.
And then around 5:20 p.m., Chief Financial Officer Dave Wehner addressed analysts and dropped one bombshell after another, rattling investors and raising red flags about whether Facebook’s powerful moneymaking machine is starting to sputter.”
…By 5:52 p.m., Facebook shares had plunged 24% to $164.99. Shares eventually recovered slightly late Wednesday evening.
“I think many investors are having a hard time reconciling that type of deceleration, considering how good the advertising-advertiser feedback is on your platform,” Jefferies analyst Brent Thill asked toward the end of the call. “It just seems like the magnitude is beyond anything we’ve seen, especially across the number of tech that we all cover.”
Ms. Sandberg replied: “I mean, even at decreasing growth rates, we are still growing and predicting growth at very healthy rates.”
All together, it was a remarkable turn of events, given that most analysts had expected the social-media giant to deliver yet another stellar earnings report. Instead, they must grapple with the question of whether Facebook, too, has limits.”
The selling continued into the next day and a large gap developed in the stock.
Now traders must decide if FB is a bargain, after the crash.
Precedent Weighs Against Further Selling
After the stock plummeted, analysts searched for precedents of a stock gapping significantly lower from a 52-week high. There were few examples but among the recent ones is the chart of Gilead Sciences from 2012.
This is typical of the pattern seen in the nine examples of a 15% gap lower in stocks that were within 5% of a 52-week high. Notice in the chart that there is neither a big move up or down. The stock price stabilized near the day’s open.
If history is correct, there is no reason to expect a large move in the price of FB and a spread strategy could generate income from the stock as traders await additional news from the company. While waiting, the stock is likely to show a sideways trend with a drift to the upside.
Trading the Trend
When a stock is expected to move higher, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for FB
For FB, a bull put spread could be opened with the August 17 put options. This trade can be opened by selling the August 17 $165 put option for about $2.00 and buying the August 17 $170 put for about $1.10.
This trade would result in a credit of $0.90, or $90 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($170 – $165). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $410 ($500 – $90).
The potential gain is about 22% of the amount of capital risked. This trade will be for about three weeks and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.