Ideas for a Facebook Option Trade

08/08/2012 4:18 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Expert trader and author Dan Passarelli shares his strategies on how one might trade Facebook using options.

Well, of course the hot IPO recently was Facebook, and now options are available. So my guest today is Dan Passarelli to talk about that—whether they are a good trade or a bad trade.  Dan, what are your thoughts on Facebook options?

Facebook options can be a great trade.  It depends, of course.  Now, Facebook options offer certain advantages over simply trading the stock.  When the stock IPO’d recently there was a lot of excitement about it.  There were a lot of people who bought it up on day one, and we all know what happened since then.  The stock fell drastically.  There’s been a lot of volatility.

So instead of buying the stock and assuming a pretty big risk—because you could be dreadfully wrong, as we’ve seen—instead, you can use options to trade a more limited-risk strategy. 

What do you recommend?  Give us kind of a garden-variety options strategy for Facebook.

Sure.  Well, imagine that a trader is bullish on Facebook.  Well, what the trader can do is buy a debit call spread.  So in this case, the trader buys a call—usually an at-the-money or at least near-the-money call—and then sells a higher strike call.  

Now, the advantage here is that the trader spreads off a little bit of his risk on a call he is buying—the real part of this play is the call that the trader is buying—but when the trader sells the other call it offsets the cost, for one, and it also offsets the volatility.  Because Facebook’s stock is so volatile, the options have a really high volatility premium built into them—they are expensive.

So instead of going out and buying this very expensive option, I buy one expensive option, but then I sell one expensive option so that we offset that volatility premium. 

And I am maybe limiting my profit in a trade like that, right, but I am also limiting some of the risk, too.

Exactly.  If a trader is thinking about maybe buying one call to profit on Facebook rising to a certain point, they might consider doing two spreads. So you would be investing about the same amount of cash, but you would make more if the stock rises, and of course, if the stock really rises drastically—you’re right—your profit is limited, and you might have to do an adjustment at that point.

What about the open interest on a newer IPO?  Facebook is so much in the news that it may have a lot of open interest, but for a typical IPO, should I wait to trade the options until that open interest grows?

Not this one.  Facebook options, on the day they started trading, it was one of the most actively traded option classes on an opening day ever.  It was incredibly active—super-high volume and, consequently, there is super-high open interest.

Dan, thanks for being here.

Thanks.

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