The meta heads into the close after Wednesday’s bell with the fundamentals largely intact.
Thanks to improved ad pricing and clearer targeting, sales continue to grow by around 30% year-over-year, a respectable number for a company of this size. The options market is pointing to a massive 7.5% gain by the end of the week. That’s a lot of money for a company of this size, but it’s justified given the big moves Meta has seen recently following earnings (shares have risen more than 10% following earnings in three of the past four quarters).
We’ve seen massive call buying recently. For example, June’s in-the-money 620 strike call saw significant buyers on Monday. The May $675 calls are similar, with much lower costs and a particular focus on returns.
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Personally, I’m not going to buy the stock, and I’m not going to buy either of these two calls. Instead, I would consider trading a spread, specifically a 625/680/750 call spread risk reversal, selling a 625 put and a 750 call to fund the purchase of an at-the-money call with a 680 strike.
Here’s why:
First, technically, despite the solid fundamental backdrop, the technical side is a bit more uncertain. This reversal could be a head fake, as the meta has been hovering around the 150-day moving average and has recently fallen below it. Other technical signals such as the Commodity Channel Index and Bollinger Bands also indicate that the stock’s position is unstable.
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meta, 1 year
Second, a quick review of stock performance relative to earnings shows that buying stocks in print is a bit of a coin toss. Did stock prices often rise in the two weeks after earnings? Yes, but just barely. The histogram below shows that a purchaser of the stock would have earned an average return of 0.92% by purchasing META in the earnings print and then holding it for two weeks. This works out to be an annualized rate of return of almost 16.8%. This isn’t terrible, but it’s not necessarily the risk/reward ratio we’re looking for given the volatility of returns. Below is a histogram showing what its earnings have looked like over the past 44 reported quarters.
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Buying calls offers a distinct risk and does not penalize some of those larger drawdowns, but this is certainly attractive. That’s probably what the buyers of May’s 675 calls were thinking. As shown here, keep the downside to a minimum while keeping the big upside.
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Indeed, the decline was limited to just 5%. The problem here is that the premium paid forces the stock to move higher than the call strike price, so you lose less on a big decline, but you lose more often. In fact, historically, spending 5% on an at-the-money call option that expires in two weeks will result in an overall loss.
Here, the purpose of call spread risk reversal is to reduce the upside break-even point, reduce the downside exposure, and increase the probability of success.
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Note that you win much more often with call spread risk reversals than you do with buying stocks or buying calls. You still take the risk of owning the stock, but since the short put option is 8% below the current stock price, the worst-case loss is always at least 8% better than the risk of buying the stock, and losses of less than 8% of the stock price are completely avoided.
The tradeoff is that the upside gain is capped at 8%, and Meta has made several post-earnings moves well above that, but overall, the improved win rate of trades means that the average historical performance of such trades is better than long stocks and short-term at-the-money calls. In this case, such a trade would average about 1.6%, or almost 29% annualized.
Less risk. Please make more.
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