By Jeff McAllister
VP of Education, OptionsANIMAL
When an IPO creates as much excitement and fanfare as Facebook (NASDAQ ticker symbol: FB), it's tempting to jump right in and buy the stock. But if you are an option trader, you're going to have to wait.
It seems that every news channel, blog, or investment program mentions the Facebook IPO at least once every 30 minutes. The IPO is now expecting to price between $34 and $38 per share and is going to be a volatile one. I suspect that the trading range for opening day will be significant.
If the Bulls are right, Facebook will head towards $50 a share. If the Bears are right, $25 per share is more likely. We won't know the real value of Facebook for some time. It will take the market several days to settle down on what it believes is a fair valuation. If you simply trade the stock it could be a very bumpy ride. For many of us, the more suitable alternative would be to trade the options around the equity. There's only one problem, there won’t be any options on Facebook for at least six days. Options industry rules specify that options cannot be listed and traded for at least six days after the IPO. When options do become available, it could a bumpy ride.
Options for Facebook will almost certainly become available after six days. However, they are likely to be very expensive. The expectation for Facebook’s share price is uncertain due to its popularity and the inability to determine its fundamental value. Market Makers are going to have a difficult time developing expectation of price movement and they will increase the implied volatility of the options. Increased volatility with make the options more expensive. As Facebook develops a trading history, Market Makers will develop better expectations and option prices will decline.
In the most recent SEC filing, Facebook revealed that 337.4 million shares are being offered in the IPO. According to sources, the IPO was oversubscribed. This indicates that Facebook is likely to open at the higher-end of the price range and then go higher as supply and demand attempt to reach equilibrium.
The point of bringing all this up is that it contributes directly to the pricing of options once they become available. In the process of carrying out their duties, Market Makers often need to take a position either long or short with the underlying equity, to mitigate their risk. The two most common trades Market Makers use to mitigate risk are called conversion and reversion.
A conversion is nothing more than a collar trade. The Market Maker buys the stock, buys a long put, and sells a short call. Both options are priced at the same strike price, and have the same expiration series. A conversion would be the appropriate hedge for the Market Maker if you, the retail trader, have sold a short put or purchased a long call.
A reversion can be thought of as a reverse collar trade. In a reversion the Market Maker shorts the equity, buys a long call ,and sells a short put.
So what does this have to do with the pricing of options? The answer lies in that the stock will initially be hard to borrow, and the Market Maker may have a difficult time carrying out his task using the conversion or reversion trades. So he will be forced to look into other types of more complicated trades to mitigate his risk and make a market with Facebook options. These other types of hedges will carry additional costs, which will be passed along to the buyer and seller of options.
The Facebook IPO is a very exciting event. It’s tempting to jump right in and trade Facebook because of all the hype and expectation of bullishness for the stock. Trading just the equity, without options, creates unhedged positions and therefore unhedged risk. Until options become available, and they have had enough time to establish valuation for Facebook, it will be a difficult stock to trade. In this situation the lost opportunity is preferable to lost capital. I'll sit tight for the first couple of weeks and wait for the market to tell me how I should trade Facebook.