Monday, November 26, 2012

FB: Into the gap

Facebook Inc. (FB) gapped past its high for the past 55 days: $24.68. More important, the rise carried the price into the gap left by the stock's fall on July 27, as it tumbled down to the channel where it has meandered ever since.

The price had in fact first broken past the 55-day high two trading days earlier, but without the strong momentum seen today. So I'm treating today as the breakout point, although that is a bending of the rules.

Facebook has proved to be the premier drama queen of the markets. As it charges into the July gap, the question to ask is whether we're seeing General Patton and his tanks driving into Germany, or Lord Cardigan leading his cavalry in the Charge of the Light Brigade.

When FB gapped last October, I wrote in "FB: A gap, but not quantum leap", about the two orbits that have marked the stock's behavior since the company went public in March. The price remains below the floor of the upper orbit -- $26.73 -- but it is for the first time approaching that level in a break above the lower orbit's ceiling -- $23.37, with a few head-fakes mixed in to keep things interesting.

For the near term, the chart shows a clear uptrend: A low of  $18.80 on Oct. 19, a high of $24.25 on Oct. 24, a higher low of $18.87 on Nov. 12, and now a higher high of $26.05 (so far) today.

The volume is higher than that of the last week, but since it was a holiday week, that fact adds nothing to the analysis.

Facebook -- the company -- needs no explanation. It's one of the great cultural names of our time.

Analysts have grown more positive about the company in the last three months; an index based on their recommendations shows enthusiasm more than tripling, from 7% to 24%.

To a remarkable extent for a company perceived as being an innovative growth prospect, return on equity is quite low, standing at 6%. On the other hand, long-term debt is also low, at a bare 4% of equity.

The company has released only two quarterly earnings since going public, each with identical earnings per share and with virtually no surprise compared to analyst expectations.

Institutional ownership is way low, at 35%. Yet the price is way high; it takes $11.22 in shares to control a dollar in sales.

From a fundamental standpoint, at this stage, FB would be a foolish purchase in my book. If I had a very long term trading horizon, I might stash some shares away in a corner of my portfolio, hoping to cash in big some years down the line.

But my horizon is much shorter, and therefore fundamentals don't count for much in my trading decisions.

FB's strong upside break into the July gap signals to me that there's something's happening here. (What it is ain't exactly clear. For what it's worth.) For my style of trading, the proper course is to jump aboard for awhile and see where the train goes.

For triage, when selecting among trade possibilities, I score the price movement for the past five days.

If it's an upside breakout, I see what percentage of the lows for those days represented a higher low from the prior day. By that measure, FB did outstanding, at 80%.

I also calculate the price difference between the close the day before the breakout, and the close five days earlier, convert it to a proportion of the average true range, and then combine that (by multiplying) with the percentage of higher lows, to produce a trend score that shows very near term momentum before the breakout.

FB's trend score is quite low, at 0.32. (By contrast, my other breakout trade today, MO, scored 3.42.) I will argue that the push into the July gap is of sufficient importance to overshadow the trend score. We shall see if my thinking is correct.

FB on average trades 92.3 million shares a day, making it one of the most liquid individual issues on the market.

It supports a very wide range of option strike prices with open interest near the money running to five figures. The front-month at-the-money bid/ask spread on calls is 3%.

Implied volatility is high compared to other stocks, at 49%, yet it stands near the bottom of the six-month range. Volatility has been rising since Nov. 21.

Options are pricing in confidence that about two thirds of trades will fall between $22.21 and $29.55 over the next month for a potential gain or loss of 14%, and between $24.12 and $27.64 over the next week, for a gain/loss of 7%. The one month gain or loss is seven times the average trading range, and the weekly, four times.

Two hours before the close, the fair-price zone on today's 30-minute chart runs from $25.47 to $26, encompassing about two-third of transactions surrounding the most-traded price, $25.84. The stock is priced at about the most-traded price.

FB next publishes earnings on Jan. 23.

Decision for my account: I opened a bull position, structuring it as a bull put vertical spread, short the $24 December put options and long the $23 December puts, for a $22 credit per contract. The break-even point is $23.80, slightly above a stop/loss at $23.62, which amounts to twice the average daily trading range. The potential yield of the position is 17%.

My rules tell me to hold this spread until it expires. If the price should rise enough to trigger additions to the position, I'll buy March call options with deltas near 70, and apply a trailing stop/loss amounting to twice the average daily trading range.


My trading rules can be read here.

And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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