How to trade Twitter (TWTR)
Everyone wants to own a piece of a hot stock. When companies have an initial public offering (IPO) and become publically traded, there is usually a lot of
buzz. Twitter (TWTR) was certainly no exception.
Twitter went public on Wednesday, November 6, 2013. The stock was initially priced at $26 per share which correlated to $18 billion valuation of the
company. But it actually opened at $45.10, which places the valuation at $31 billion – roughly $220 million for each of its 140 characters. Or, with 232
monthly users, that’s roughly $1,350 per user.
Am I the only one who thinks that seems a just a little too high?
Since opening, Twitter’s stock has essentially meandered sideways, closing slightly lower to $44.69 on Friday, November 15, 2013.
To some traders, this may seem similar to the IPO of Facebook (FB). On May 18, 2012, Facebook opened at $42.05, which was higher than initially expected,
and it ran up to $45.00. Traders who jumped on the IPO bandwagon of Facebook took a beating as it fell to a lower $25.52 in the matter of a few weeks –
loss of 43%. Patient traders found that their investment eventually became because FB is now trading higher – but it took over a year to get there.
While Twitter does not have some of the exchange issues that Facebook faced during its IPO, the first few trading days of Twitter seem familiar.
Does that mean you shouldn’t jump on the TWTR bandwagon?
I cannot tell you what you should do, but I can tell you how I might trade it. One thing for sure is that I would not buy the stock – not at least without
some sort some options to help protect it. With a long stock position, your risk is defined as the total investment. While you wouldn’t expect to TWTR to
go to zero, a 20%, 30%, or 40% drop is not inconceivable.
Options are essentially insurance policies. Long Puts generally make money when a stock drops. Long Calls generally make money when a stock pops. However,
like an insurance policy, the price of that policy is based on addition factors. The two most significant factors affecting the price of insurance are the term of the policy and the risk.
For the term, there would be a different price for year, a month, or just a few days.
The risk can be a nebulous concept because is based on expected events in the future. For an insurance policies, it costs more to buy car
insurance for a 16 year old boy than it does a 55 year old woman. The pricing would be reverse if we were talking about a life insurance policy. It’s based
on the perceived risks.
In the insurance industry, there are actuaries who specialize in assessing and pricing the policies. In the options industry, the market determines that
risk and it is expressed by the Implied Volatility.
As of Friday, November 15, 2013, options are now available on TWTR. This provides traders with a number of ways to control risk, speculate bullishly or
bearishly, and generate income.
Most novice options traders would look at buying long options to speculate on a direction. For example, if he were bullish on TWTR, he might buy a December
$45 long call. That option expires in about a month and costs $2.35/share for a 100 share contract. One contract would cost him $235 to control 100 shares
of TWTR. Alternatively, the trader could chose to buy 100 shares for $44.69/share or $4,469. The Long Call certainly has an attractive price point. If the
stock makes a relatively fast move up the call will gain in value. However, like an insurance policy, the value usually decreases as time moves forward. By
expiration, stock has to be higher than the long call strike ($45), plus the price of the call ($2.35) to breakeven ($47.35.) If the stock were to trade
even higher, e.g., at $50, the long call would be worth at least $5.00/share – netting the trader a $265 profit.
However, the odds are stacked against that trader.
With options the following three things are always in balance:
- Probability of making a profit
- Maximum risk
- Maximum possible profit
You cannot get a high probability, low risk, and high profit trade. In the case of a Long Call, you have low risk and high profit potential.
(Theoretically, long calls have infinite profit potential.)
In the case of buying long stock, you have about 50% of making money. For that specific Long Call, there is about a 34% chance of making any profit.
Probability is what you have to give up to risk less capital and have infinite upside.
What if the trader decided that, rather than looking for infinite upside, he wanted probability on his side? In that case, a trade like Bull Put (a.k.a., a
put vertical credit spread) could be more attractive. For example, a trader could chose to sell the December 44 long put and buy the December 39 long put
for a net credit of $1.90. The trader would receive $190 for each pair of contracts. The maximum risk would be $310 and the trader has about a 62% chance
of making any money at all.
In the case of the Bull Put, the trader is giving up the infinite upside, but has a higher probability of making any money. For this trade, the breakeven
is the Short Put strike ($44.00) less the credit received ($1.90) and is $42.10.
Which situation do you like better: Making money with TWTR being above $42.10 or $47.35?
Personally, I like the idea of the lower breakeven. To use an example of baseball, this is small ball – base hits – rather than swinging for home
run. There is a place for speculation with Long Calls for bulls and Long Puts for bears. However, in the long run, I think it’s better to have probability
on your side.
Now, the thing to remember is that while the Bull Put does have probability on your side, it still can go against you. And your maximum loss is bigger than
your maximum profit. So, a trader must consider strategies to mitigate that risk.
This is why it is essential to place the right trade in the first place and have a trading plan in place before placing a trade:
- Primary Exit: When do you take profits
- Secondary Exits: What do you do if the trade goes against you?
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