When studying covered call writing we learn to master stock investing as well as option trading basics. Then we become elite investors by focusing in on the inter-relationship between the two. In this regard, a story most of us have been following the past two weeks has been the initial public offering (IPO) of Facebook (FB). The initial sale price was set @ $38 on May 18th. After opening, the stock price skyrocketed to $45 and settled at the end of the first day of trading at $38. Was this a coincidence? At the time I started writing this article, the price was down to $28.19. This week’s article will explore the role of options in the price behavior of Facebook that first day and introduce the Greenshoe option, perhaps a new name to many of our members.
Definition:
A Greenshoe option is a provision contained in an underwriting agreement that gives the underwriter (Morgan Stanley was the main underwriter , in this case) the right to sell investors more shares than originally planned by the issuer (Facebook, in this case). The purpose is to provide price stability as the underwriter has the ability to increase supply and compensate for price fluctuations if demand increases.
The Facebook story:
On May 18th, Morgan Stanley sold $484 million shares of FB @$38 per share and simultaneously bought 421 million shares from the company and investors @ $37.58 generating an initial 1.1% profit which represented the underwriter’s fee. Not bad!
In essence, Morgan Stanley shorted 63 million shares of FB which represents the greenshoe. From Facebook’s perspective, shorts eventually need to be covered resulting in upward pressure on the stock price. It also provides market liquidity if there is great demand for the stock. Now from Morgan’s perspective this was not truly a “naked short” because of the greenshoe option which gave them the right to go back to Facebook and purchase an additional 63 million shares @ $38 (less fees). So what were the possibilities?
1- The IPO is a huge success and the price moves higher. Then Morgan sells those shares to the anxious buyers.
2- The IPO is a dud and the price declines. Now Morgan will cover the short by buying back shares @ market price. This buying action will tend to support share price at least for that first day. It was, in fact, no coincidence that on May 18th whenever the price declined to around $38, large blocks of shares were purchased.
To further support this scenario, look at these stats from Friday, May 18th:
- 43 million shares were bought at EXACTLY $38 per share
- 28.5 million shares were purchased at $38.01
Common sense tells us that most of that buying was Morgan Stanley attempting to support the share price of an unsuccessful IPO.
On Monday, May 21st, it appears that the greenshoe was exhausted as the price plummeted to $34 as shown in the chart below:
Facebook and the Greenshoe option
Practical application:
When an IPO is introduced there is a lot of speculation and excitement regarding the direction and strength of a price movement. Many retail investors will buy a stock like Facebook because it is ubiquitous and synonymous with success. It’s tempting to hand over our hard-earned cash to be part of the American dream. Understood. Now, with the knowledge of the role of greenshoe options for the underwriters we can watch the price action of the stock on the first day of trading. An initial pop is understandable, almost expected. When we subsequently see a drop in share price and then buying to keep the price at or about the original IPO price we can make the leap that the greenshoe effect is kicking in. That gives us an opportunity to get out at the $38 price. True, that may be a loss but $38 seems a whole lot better than the under $28 I’m staring at today as I type these words.
Conclusion:
Covered call writing is not only a great investment strategy for many investors but also represents a fabulous educational background to learn and understand the practical application of stock and option investing. Although the Facebook story is not directly related to our covered call writing investing at this point in time it does represent an interesting story where we can put our knowledge and skills to practical use in understanding a dynamic that few others can comprehend.
Note:
The term “greenshoe” comes from Green Shoe Manufacturing, the first company to allow underwriters to use this strategy. This is the company we know today as Stride Rite Corp.
June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:
To sign up (seating is limited):
Time: 6PM to 7:30 PM
Admission is FREE and non-members are welcome.
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Cashing in on Covered Calls:
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Exit Strategies for Covered Call Writing:
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Market tone:
This week’s economic reports were predominantly negative and suggesting a slower recovery than previously anticipated:
- The economy added 69,000 jobs in may lower than the 150,000 expected
- Construction spending in April came in up 0.3% with 0.4% expected
- Consumer confidence level was at 64.9 lower than the anticipated level of 70
- 1st quarter GDP was at +1.9% as expected
- Initial jobless claims (383,000) was higher than expected (370,000)
- The ISM manufacturing index reflected expansion @ 53.5 but slightly less than the 54 expected
For the week, the S&P 500 dropped by 3% for a year-to-date return of 2.6%, including dividends.
You don’t need me to tell you that the market technicals have broken down with the S&P 500 down 6% in the past 6 months while the VIX has climbed by 55% in that same time frame:
Market technicals 6-1-12
Summary:
IBD: Market in correction
BCI: Cautiously optimistic on the US economy but concerned about market volatility and signs of an even more sluggish recovery. Add to that European concerns and a Congress in gridlock we have a higher level of risk than in normal market conditions. As a result this site is using ONLY low beta stocks or ETFs with ONLY in-the-money strikes. It is more critical than ever to use every exit strategy opportunity when indicated.
My best to all,
Alan([email protected])
Really interesting article. I usually don’t go for IPOs but did buy 300 shares of facebook maybe because I use it so much. Needless to say I’m not too happy right now. I don’t know if I’ll go for another IPO on the first day but if I do i’ll keep this information in mind. Thanks for sharing.
Brian
Premium Members,
The Weekly Report for 06-01-12 has been uploaded to the Premium Member website and is available for download. Due to technical difficulties, the report has been uploaded in two parts…Weekly Stock Screen And Watch List 06-01-12 Part 1 of 2, and Weekly Stock Screen And Watch List 06-01-12 Part 2 of 2. Please be sure that you download both parts.
Have a great holiday weekend.
Best,
Barry and The BCI Team
Cramer advises never to buy an IPO on opening day. I guess he was right here.
Alan,
On your weekly ETF report some are shown in chart form and others are just listed. Can you explain the significance of this?
Thanks.
Susan
Susan,
The ETFs in chart form have the highest 3-month returns of the eligible funds. This report has evolved over the years based on member feedback. Originally, we listed only the top 5 or 6 funds. Since then we added the top 3 SPDR Select funds, inverse ETFs and another 10-12 top-performers.
Alan
Alan, really interesting about the greenshoe effect.
The Facebook IPO was also a great reminder for us retail investors that just because we use a product and therefore think we understand it, does not mean we understand its business model. While the talking heads on tv are often wrong, this was one they got right as they were all raising the issue for days before the IPO about its questionable business model. Until Facebook proves it can make money, for any of us to buy it even at $28 is just speculation.
Markman Hearing:
As we approach market open this morning, one of the most actively traded stocks today could be VRNG. This company has a patent infringement lawsuit against Google and the Markman Hearing is scheduled for today. A Markman hearing is a pretrial hearing in a U.S. District Court during which a judge examines evidence on the appropriate meanings of relevant key words used in a patent claim. It is also known as a “Claim Construction Hearing”
Markman hearings are important, since the court determines patent infringement cases by the interpretation of claims. A Markman hearing may encourage settlement, since the judge’s finding can indicate a likely outcome for the patent infringement case as a whole which is scheduled for October 16th.
Since we had such positive feedback from this week’s article regarding greenshoe options, I thought this may also be a topic of interest for our members.
Alan
This week’s Barrons suggests that if you want to own Facebook you should get paid to do so. Sell a naked Jun $25 put. If it drops below $25 you win(?), and your cost will be less than $25. If it does not drop below $25 you win again, because you keep your money, and you keep the other guy’s money.
Owen,
Really happy to see you on the blog again.
Best,
Barry
Alan,
I’ve been a premium member for 2 months and have been paper trading as you recommend for 1 month. I’ve been looking at the Select Sector SPDRs in the etf report as a conservative way to get started. I figure about 10k for each of the 3 top performers. Your thoughts?
Thanks for all your help.
Tony
Tony,
This is certainly a viable plan both from the perspective of a beginner and for the size of your portfolio. Using the 3 SelectSector SPDRs will give you exposure to the top-performing one third of the S&P 500. It will provide instant diversification and the share prices fit your portfolio requirements. If the returns meet your goals this is one of the strategies you should consider.
Alan
If a stock is trading right at the strike price will the stock be sold? If I want to keep the stock should I roll out?
Thanks,
Carol
Carol,
As we approach 4PM EST on expiration Friday, a stock trading right at the strike price has a strong possibility of being sold. If trading slightly under the strike, pinning the strike (institutional hedging forces- see pages 433-437 of “Encyclopedia….”) could force the price up to or slightly beyond the strike. Even if the price ends up one penny above the strike, the stock will most likely be sold. If your intention is to hold onto the stock, your best path would be to roll the option.
Alan
LULU had a strong earnings report today but weak guidance. Down 8%. Avoiding earnings reports is Alan’s best rule!
Fred
Fred,
Thanks for pointing this out. For beginners, “paper trade first” is AT LEAST as important, probably more.
Alan
Fred,
I had LULU since March. Brought my cost basis down around $69 as of last week. A few days ago I sold a protective Put (for protection over the earnings event) for on the Weekly expiring tomorrow. This gave me the protection to get through the drop. As it turned out, the Put doubled in value and I’m just about at break even for the trade. I sold the Put at today’s high and I plan to sell more covered calls on LULU…most likely waiting a few days to see if it bounces…that is “leg-in” to the covered call trade. If LULU moves tomorrow, I’ll sell the June Call…else I’ll sell a July Call.
We one of our longer term goals for the updated website is to provide more info on Protective Puts and Collars.
Best,
Barry B
It’s not just that situation, Fred. I got smacked around when Apple reported absolutely outstanding earnings, sales and guidance. Unfortunately, the market had already run the stock up, and then some. When the earnings came out they took 25 points off the stock because they expecte a bit more.
Alan’s rule is posted on my wall just under Warren Buffet’s first rule, “Don’t lose money.”
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.
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Alan and the BCI team
I was interviewed today by Kerry Lutz of The Financial Survival Network:
http://financialsurvivalnetwork.com/