Published November 15, 2013
Traders itching to "strangle" or "straddle" the newly launched shares of Twitter Inc (TWTR) will finally get their chance on Friday when trading in the social media company's options launches on U.S. exchanges.
Just over a week after the stock's initial public offering and debut on the New York Stock Exchange, options market makers will begin pricing and trading contracts to buy or sell Twitter shares at various prices in the future.
Options are an increasingly popular way to make inexpensive bets on the direction a stock may take or to hedge existing positions in the shares. The market is rife with strategies bearing colorful names such as "strangles" and "straddles," which are bets on volatility, or even "iron condors," which wager that a stock will remain in a tight range.
Given the high level of publicity surrounding the IPO last week, Twitter's options are expected to be popular. But because of the stock's limited trading history, market makers will be challenged to price its puts and calls in the early going after the market opens at 9:30 EST.
"The trading of Twitter puts and calls will be tricky at first," said Brian Overby, senior options analyst at online brokerage firm TradeKing based in Fort Lauderdale, Florida.
The gap between bid and ask prices on the contracts, known as the spread, is expected to be wide at first, Overby said.
That could contribute to choppy trading in the first several days.
The behavior of the stock, and by extension the option prices, will likely be very unpredictable, said Brent Archer, senior options analyst at options research firm InvestorsObserver.com, in Charlottesville, Virginia. "If we look back to Facebook, that stock took about three weeks before it settled down into a defined range."
Volume should be robust, but some traders expect turnover to be below Facebook Inc.'s (FB) launch, given the micro-messaging company has a smaller number of shares and market value.
More than 365,000 contracts changed hands in Facebook's option debut on May 29, 2012, a record for the first day of option trading on a stock, according to Trade Alert. Trade Alert president Henry Schwartz expects Twitter, based on its stock volume, to trade 150,000 to 200,000 contracts on Friday.
Twitter, with a market capitalization of roughly $24 billion, is roughly a fifth the size of Facebook, valued at close to $120 billion. Twitter's IPO raised just $1.8 billion, compared with Facebook's massive, $16 billion offering.
Twitter has a smaller float compared with Facebook, and its market capitalization is lower, so it will most likely have less participation from the options market compared with Facebook just because the market will not be the same, said Steve Place, a founder of options analytics firm investingwithoptions.com.
What's more, the early weakness following Facebook's disastrous initial public offering in May 2012 brought out options participants ready to make bearish bets on the stock.
"Option players were willing to pay up for Facebook puts compared to calls because its shares were hard to borrow, and we may see the same situation in Twitter," Overby said.
Traders will sometimes use options on a stock to express a short bias when shares are difficult to borrow.
A major uncertainty in the early stages of Twitter options trading will be the determination of their implied volatility, a key component of an option's price. That measures the perceived risk for future stock movement and will allow participants to compare the risk in Twitter shares relative to social media peers and other stocks.
Place expects Twitter to trade with a higher volatility compared with Facebook or more mature social media stocks such as LinkedIn Corp (LNKD).
"A comparison of past social media stocks leads me to believe that Twitter options will open up with an implied volatility of around 60 to 70 percent," Place said.
Facebook options made their debut in May 2012 with an implied volatility near 60 percent and LinkedIn's were above 70 percent when its options trading launched in May 2011, according to Reuters data.
The hardest job for market makers with IPO option contracts is getting the implied volatility number right for each expiration available, Overby said. "This is because there's very little historical stock price data to go on."
Since Twitter went public on Nov. 7, the shares have ranged from $39.40 to $50.00. They closed at $44.69 on Thursday.
Some expect Twitter option premiums to be very high at first. "I would focus on selling premium, which we anticipate to be elevated due to the unpredictability," Archer said.