Facebook options debut a wild card for volatility

Fri May 25, 2012 3:27pm EDT

Traffic flies by the entrance sign to Facebook headquarters in Menlo Park, California before the company's IPO launch, May 18, 2012. REUTERS/Beck Diefenbach

Traffic flies by the entrance sign to Facebook headquarters in Menlo Park, California before the company's IPO launch, May 18, 2012.

Credit: Reuters/Beck Diefenbach

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(Reuters) - Investors can hope the debut of options on Facebook Inc goes more smoothly than the long-awaited debut of the social networking service's stock on May 18.

While the stock's puts and calls are expected to be popular, the big wild card is volatility and ultimately, the options price.

Traders will get a fresh start on options on the Internet giant when the contracts are offered on U.S. options exchanges on May 29. BATS Options exchange, a division of BATS Global Markets, will list the options on May 30, following its standard practice of listing new options a day later than the other exchanges.

Plenty of uncertainty surrounds the stock, which debuted to much fanfare at $38 and immediately ran into problems.

Facebook's first day of trading was marred by technological glitches, and the company faces criticism that it sold too many shares, overwhelming demand. A week later, the stock was at $31.47, down 17.2 percent.

Options volume is expected to be robust. "It's a cocktail party stock and probably will attract a lot of participation from retail traders," said Steve Place, a founder of options analytics firm investingwithoptions in Mobile, Alabama.

The stock's valuation remains high - the forward price-to-earnings ratio is at about 56, and the stock is expected to stay volatile. Premiums - the price paid for options - must reflect that uncertainty and will be even more difficult to pin down.

"The real issue like everything else in the market is about value, and with Facebook, we simply don't know what their true earnings power is at this moment," said Jeff McAllister, vice president of education at options education website optionsanimal.com in Lehi, Utah.

"The first day of trading is going to be completely speculative to begin with and it will be aggressive - flooded with day-traders trying to make a quick turn in the market. But institutions are expected to be on the sidelines waiting patiently as disciplined traders do."

The options debut will offer opportunities to hedge against or take advantage of volatility in the shares through strategies combining stocks and options.

"From LinkedIn to Zynga to Pandora and now Facebook, the evidence is clear that the one certainty for investors is share prices of social media companies are volatile and will likely remain so," said Gareth Feighery, a founder of options education firm MarketTamer.com in Philadelphia.

PRICING RISK AN UNKNOWN UNTIL TRADING OPENS

Before the IPO, investors had an anchor on what to expect regarding the share price. But in the options market there is no indication of what the demand will be.

So implied volatility, a key component of an options price, which measures the market's perceived risk of future share price movement, remains an uncertainty until the first transactions.

"Figuring out the implied volatility is a chicken-and-egg scenario - that value won't be known until the market opens up, when market makers will gauge the supply and demand to price risk," Place said.

If there is significant demand for options, either through speculators or hedgers, the implied volatility will be elevated, and the price of the option will rise.

Place looked at the implied volatility readings of LinkedIn, Groupon, Pandora, Zynga, Yelp and Zillow from the day their options opened on each of these stocks as well as the stock and options volume.

"Using these past values as a guide, we can expect Facebook options to have a 30-day implied volatility between 65-85 percent," he said. "The mid 70s would be a good estimate."

Facebook is currently valued at about $87 billion, based on a share price on Thursday of $31.88. Shares of the much-anticipated initial public offering have fallen sharply since they opened at $42.05 on May 18.

The company went public at a valuation that built in no margin for error, Feighery said.

GRAB A BOX OF POPCORN AND WATCH VOLUME

Almost 23,000 contracts traded for the first day of LinkedIn, equivalent to 1.3 times the stock volume for that day, according to options analytics firm Trade Alert.

Applying that same multiple for Facebook and assuming it mellows out at 60 million shares per day would equate to almost 800,000 option contracts, said Trade Alert President Henry Schwartz. That may be unlikely since that would exceed the average daily option volume of Apple Inc of about 750,000 contracts.

"We could easily see a couple hundred thousand contracts trading for Facebook options simply because the underlying share volume is so strong and there is so much hype about the IPO," Schwartz said.

Options clearinghouse OCC has designated NYSE Amex Options, owned by exchange operator NYSE Euronext, to be the primary market for Facebook options. Initial strike prices below and above the share price are from $16 to $49, in $1 increments.

(Reporting by Doris Frankel in Chicago; editing by Matthew Lewis)

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