Market Sentiment (Stocks on NYSE, NASDAQ, AMEX)

Feb. 13, 2013, 2:50 p.m. EST

Liking the Facebook skew

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About Andrew Giovinazzi

Andrew Giovinazzi was a member of both the Pacific Exchange and the Chicago Board Options Exchange where he made markets in both equity and index option classes. During that period he never had a down year. In 1991, Andrew started and ran the Designated Primary Market Maker post for Group One, ltd in Chicago. In 2001, he co-founded Henry Capital Management. He became Chief Options Strategist and Option Pit Mentoring in the Fall of 2011. Andrew has a Bachelor's degree from the University of California, Santa Cruz in Economics. /conga/trading-deck/bios/giovinazzi_andrew.html 230100
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By Andrew Giovinazzi

Early bull markets are generally quiet. Why? No one believes them that's why. Most of the time investors are waiting for the selloff or still stinging from the last bear market. It is hard to believe that in the summer of 2011, the SPDR S&P 500 ETF Trust (SPY) was trading 108 and it is now near 50% above that level.

Part of the way I have been writing this column since November is generating idea to get investors into stocks with potentialLY below-market prices. We can't buy SPY at 108 anymore, but we can look for names with good conditions in the options. Let’s take a look at Facebook /zigman2/quotes/205064656/composite FB -2.71% .

As I said before, most of the trades that I have suggested were operating below current market prices. Mostly selling put spreads below the market into and through the fiscal-cliff talks. In general, I think that still works, but implied volatility (IV) is now much lower so investors are not getting as much bang for the buck on put spreads. Implied volatility starts to do funny things when the at-the-money volatilities get really low. Investors see the skew in the options start to pick up.

First, here is a short primer on skew in option pricing. The option model uses one, flat, forward underlying volatility to generate a price. Equity markets don't quite work that way when the movement pitches down or pitches up, so the skew is an adjustment for changing movement.

Investors buy protection in the form of puts, and liquidity providers price this in by raising IV all the way down the volatility curve. This is a simplification, but basically how it works. The same can be true on the upside for products that see more upside risk like the commodities, the VIX and some very speculative equity names. That is what we find in FB now. Paper is buying up the cheaper out-of-the-money calls pushing up the implied volatility away from the at-the-money options.

Note in the skew chart linked below that the bottom of the curve is at-the-money. This is a sign of the very low implied volatility as underlying volatility is at all-time lows. From my point of view, this allows me to take a more aggressive stance in names I like using the skew to my advantage.


Facebook skew charts by charts from Livevol (r)

In the case of Facebook, one example of a way investors could potentially capitalize is to buy at-the-money call spreads for very cheap prices in March and beyond. I think the ideal is probably April.

Since I am a volatility trader first and a fundamental trader second, I think FB goes higher at some point between now and April, and with option prices so cheap, it does not need to do much. The risk/reward looks very nice to me. In terms of the trade itself, it would entail buying a Facebook Apr 28 call and selling a Facebook Apr 31 call and holding it. The spread brings the risk down considerably and drops the time decay to acceptable levels.

The idea of this trade is that FB does not have to move up much to generate a decent return on the spread.

Disclosure: Mr. Giovinazzi has positions in Facebook.

US : U.S.: Nasdaq
$ 328.88
-9.15 -2.71%
Volume: 5.98M
Nov. 30, 2021 11:03a
P/E Ratio
Dividend Yield
Market Cap
$940.32 billion
Rev. per Employee

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