How to use weekly options to protect Facebook (FB) gains

Dr. W. Edward Olmstead is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dates & Numbers Updated 1/5/13

Now that many stocks have weekly options, there are new strategies available to protect the price of a stock following an earnings report. Stocks often experience their biggest declines in price after an earnings report fails to meet the expectations of investors. Weekly options can offer cheap, short-term insurance to lock in a minimum sale price of a stock that is vulnerable to an earnings setback.

It has always been possible to use monthly put options to protect the price of a stock through the date of the company’s earnings report. The problem with monthly puts is that they can be quite expensive, particularly when the expiration date is substantially later than the earnings report.  Weekly options are cheaper and offer more flexibility in providing short-term protection.

Not all stocks have weekly options, but when they are available, it is prudent to know how to employ them to circumvent an earnings report disaster. A timely illustration of a protective options strategy will be presented for Facebook Inc (NASDAQ: FB), which has its next earnings report on January 30, 2013.

FB stock is currently trading around $28, which represents a nice 40% increase since mid-November. With the company’s earnings report scheduled for January 30, there is concern about losing those recent gains if the report is less than spectacular. Let’s explore an inexpensive strategy to protect the price of FB by using a combination of weekly options.

This protective strategy assumes the ownership of 100 shares of FB stock. While this trade may be appropriate for the protection of FB stock purchased at any price, it is designed primarily for stock purchased below the level of $27 per share.

It is easiest to present this protective strategy as a combination of two separate trades. The first trade is the purchase of a weekly put that expires two days after the FB earnings report. For 100 shares of FB stock, buy one contract of the Feb 27 put that has an expiration date of February 1. The current cost of this put is $1.25 per share. This put will allow you to liquidate your stock for $27 per share if the earnings report on January 30 leads to a collapse of the FB stock price.

The second part of the strategy is intended to lower the cost basis of the long Feb 27 put. In this second trade, sell one contract of the Jan 30 call and one contract of the Jan 26 put, each of which expires on January 25. Currently, the premium received from the sale of these two options is $.70 per share. This sale will reduce the cost basis of the long put from $1.25 per share down to $.55 per share.

The recent price range of FB stock will likely hold for the next few weeks leading up to the earnings report on January 30. This suggests that the short Jan 30 call and short Jan 26 put will expire worthless on January 25, five days before the earnings report.  The residual option position will be long one Feb 27 put with a cost basis of $.55 per share that is valid through the week of January 28 –February 1. With the FB earnings report on January 30, there will be two full days after the report to observe the response of the stock price.  If the price of FB stock falls significantly after the report, the stockholder will have the choice of either (i) liquidating the stock at $27 per share or (ii) selling the Feb 27 put for a profit that will offset some of the loss in the stock price.

Of course, it is possible that the price of FB stock will be either above $30 or below $26 when the expiration date of the short options arrives on January 25. If the stock price is above $30, the short put will expire worthless and the stock holder can choose to either buy back the short call or allow the stock to be called away for a nice profit. If the stock price is below $26, the short call will expire worthless and the diagonal spread composed of the long Feb 27 put and short Jan 26 put can be sold for a profit.

While this weekly options strategy was presented as a protection for actual shares of FB stock, it applies equally well for an options position that represents synthetic stock. In a Seeking Alpha article of August 15, 2012 (with follow up commentary), I presented an options approach to safely construct a synthetic long stock position in FB. The protection strategy presented here can also be used in conjunction with that synthetic holding.

 

- Dr. Olmstead


OlmsteadOptions has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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