Facebook Earnings Preview

Facebook (FB) will report quarterly earnings after the close today and a great deal of media attention is focused on the event, with bulls pointing to mobile monetization and ‘key growth initiatives’ and bears suggesting the rapid share-price appreciation may indicate a potential bubble to be avoided (or even shorted!)

Options flow provides an interesting quantitative and qualitative way to gauge expectations and sentiment heading into the event, especially since Facebook options have become one of the most active listings this year- 65million contracts traded YTD, with average daily volume near 540,000 contracts .  FB has even given the longstanding single stock option volume leader Apple (AAPL) a run for it’s money-  beating AAPL for top position 37 days this year.  Total open interest in FB surpassed that of AAPL in July this year and has never looked back- currently 4.57million FB contracts are open, vs 2.93million AAPL.

So let’s take a look at what the options markets are telling us to expect around tonight’s release. Magnitude of the expected earnings ‘gap’ can be inferred from the option prices in the short-term (weekly) contracts versus those in longer dated terms.  Tuesday’s closing prices shows front-term implied vol near 172% (yes, that’s correct) with longer dated terms priced near 55%.  That differential is purely related to the ‘extra’ volatility the shares will exhibit as the react to earnings.

Mathematically we can weight the calculation to account for the single-day event and get a value for the implied earnings-day standard deviation- currently about  19%- from your high school statistics class (or Wikipedia) this can be understood to mean that there is a 68% chance that FB shares stay within 19% of current spot. More sensational headlines can be generated if you consider the outside bounds on that normal distribution- a 2% chance of a 40% move!!  There are a number of imperfect assumptions involved here, but the basics are sound.

Nowadays with short-term weeklys available to trade, it’s even easier to get an estimate of the market expectation; simply look at the short-dated at-the-money straddle (if there is one).  In this case the 50 straddle in FB that expires Friday 11/1 closed near 12.5% of spot- since that is breakeven to a trader, we can use that as a good approximation of the expected move.  For FB this would be about a $6 gap. A quick look at the historical moves after earnings justifies this level and shows it’s very close to the median move over all 6 prior reports.

Directionally the flow data is more difficult to interpret, but we can take a stab at it by looking at which options have seen the greatest demand to hold into earnings.

FB Shares set an all-time closing high of 54.22 earlier this month and shares have slid back to the $50 level.  Flow this week has been heavily dominated by calls- 714K trading vs 452K puts.  A very large collar traded yesterday to open a new position in the long-term Jan15 options, where a customer bought nearly 60,000 Jan 47 puts to sell Jan 55 calls- that trade looks like a long-term hedge for a large share position (that likely doubled in value this year).  In the short-term options the 50 and 60 strike calls have the largest open interest and we’ve seen call spread buyers and ratio put-spreads trading- both pointing to an upside view into the news.  Backing up the demand for bullish exposure is the current implied volatility skew-  which is ‘inverted’ with upside strikes trading above downside for similar deltas.

Based on the flow and pricing data, I doubt we’ll see a gap as extreme as we did in July, but it’s still likely to be near $5.  That large hedge (6million shares notional) out in Jan15 tells me at least one pro is content to lock in gains here, but the short-term picture still appears bullish in Facebook

Disclosure: Writer has positions in FB options.