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Philip Guziec, CFA, On Wednesday June 8, 2011, 11:00 am EDT
Tech IPO Bubble--Redux
Investors who lived through the late 1990s might be having deja vu. They are likely seeing the recent stream of headlines about hot IPOs with no earnings that double on their first day of trading, with the value determined more by the number of eyeballs than the earnings that they deliver.
The tip-off that it has been more than a decade since we last saw these headlines is the fact that the delivery method has changed; in the old days, we heard about hot IPOs using desktop computers--now, we learn about them on mobile phones. Many investors who steered clear of the tech IPO mania last time simply sat on the sidelines shaking their heads and wondering what the market was thinking, remaining mindful that the market can remain irrational longer than an investor can stay solvent and fearful of the unlimited loss potential in shorting shares of stock.
It turns out that the option market can provide a clue about what the smart money is thinking about a high-flying IPO and a way to place a bearish bet on a company without risking one's solvency. I'll use LinkedIn as an example. The stock rose by more than 80% on the day of its IPO, after raising the valuation range before it came to market and pricing at the top of the range. Morningstar's analyst covering LinkedIn, Rick Summer, thinks the shares are severely overvalued, and the company has a Morningstar Rating for stocks of 1, suggesting that investors should be quite bearish on the shares. Morningstar Premium subscribers can read Summer's Analyst Report by clicking here.
Reading The Cues in The Prices
We can tell that there are a lot of smart investors who also think the shares are overvalued by looking at the prices of the options on LinkedIn. I won't drag you through excruciating detail on how option prices are calculated, but I will mention the common measure of option prices. Any individual option price is determined by the price of the stock, expiration date, and strike price, as well as other minor factors. The important thing to understand is that all option prices measure uncertainty about the stock price rather expectations about than the stock price itself. This uncertainty is measured on a common scale, called implied volatility, which is the uncertainty or volatility "implied" by the option price itself. Call options represent uncertainty to the upside, and put options represent uncertainty to the downside. For more background on how Morningstar looks at option prices, I encourage you to download Morningstar's guide to option investing.
As one might expect, implied volatility for LinkedIn is quite high because it is hard to value a company with very uncertain long-run earnings prospects. More interestingly, though, the implied volatility is different between the call options and the put options. Normally, the implied volatility of the call options remains close to the implied volatility of the put options because option market makers can buy or sell options and stock in offsetting amounts to capture a riskless profit. Technically, the relationship between the prices of call and put options is called put call parity. However, when a stock becomes "hard to borrow," there are a lot of investors selling the shares short, and there is no additional stock available to short to offset the sale of put options. When there is a shortage of stock to short, the prices of put options rise relative to the price of call options.
This is exactly the situation that we see in the options on the shares of LinkedIn. The table below is Morningstar's option price page as of market close June 6 for options that expire on Feb. 17, 2012.
To see the related table, click here:
http://news.morningstar.com/articlenet/article.aspx?id=383564
You can pull up Morningstar's option prices for LinkedIn for yourself by clicking here.
At the time we looked at the option prices, the implied volatility of the puts is about 77% versus 53% for the calls. An implied volatility that is 45% higher for puts than calls means the stock is very hard to borrow. In turn, this means that there are a lot of investors taking a very bearish view on LinkedIn, and backing it up with their capital.
So, somebody out there agrees with Morningstar and is trying to short the stock. We can't say for sure that the investors making the bearish bets are "smart money," but they are certainly sizeable enough to materially distort the options market.
Placing Your Bearish Bet
Making an investment using options involves making a bet on the valuation of the underlying security, the time it will take for the security to move to the level that you expect, and the likelihood of this move happening. The upside of placing a bearish bet using options instead of by shorting stock is that you can bound your risk, preventing the dreaded unlimited losses.
The longest-tenor option listed expires in February of 2012. Again, those that remember the late 1990s will know that we might be right that LinkedIn is overvalued in the long run, but in February 2012 the stock could just as easily be trading for twice what it is trading for today. Therefore, it is hard to know that one has an edge in making this bearish option investment.
However, those wishing to make a bearish bet on LinkedIn during the next nine months, given the high level of implied volatility on the company, would likely sell a call spread. This involves selling a call option at one strike and buying a call option at a higher strike to bound the capital at risk. With a call spread, one knows that the capital at risk is the call option strike prices minus the net premium received for selling the lower-strike option and buying the higher-strike option.
Using the option prices from above as an example, ignoring the bid-ask spread, selling the $85 strike call option for $13.95 and buying the $90 strike call option for $12.35 would produce a net of $13.95-$12.35 = $1.60 to the seller in exchange for putting $5.00-$1.60 = $3.40 at risk. The seller would make money if the stock closed at a price of $86.60 or below when the option expires, and after the sale of the call spread, we would recommend that the seller remain 100% cash secured, meaning that there would be $5 in cash in the account for each call spread sold. Option contracts trade in lots of 100, so selling one call contract would produce $160 in premium. And to have $500 in the cash after the sale, one would need $340 in the account before the sale.
Another interesting nuance of call spreads is that you can figure out the odds being given by the option market that the stock will close below the break-even price, which in this case is 160/500 = 32%. If you think the probability of LinkedIn closing below $86.60 on Feb. 17 2012 is much greater than 32%, you might find this to be a bet worth making.
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Philip Guziec is co-editor and portfolio manager of the Morningstar OptionInvestor online newsletter and research service, and is co-author of the Morningstar Investor Training course on Option Investing. For more about Morningstar's fundamental approach to investing in options, please use the link below to download our free guide to option investing:
http://option.morningstar.com/OptionReg/OptionFreeDL1.aspx
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