Facebook is a company for which I might have a bit of a love/hate relationship. Like the other 2.23 billion users as of the time of this writing, I spent a very large amount of time (see that understatement?) on the platform. This was especially true when I was in college and even grad school. At the beginning at least, the platform was incredibly effective at connecting classmates and sharing pictures or events. It was new, cooler than Myspace, and I loved it. Over time, the product had some iterations, and most of them were good (despite the traditional grandstanding of every user when Facebook introduced a minor design change).
Today I am no longer on Facebook. It is not because of the Russians and it has little to do when how my data is being used to target me with relevant ads (the data might not be sold technically, but let’s say it is sort of “leased” to businesses. It definitely has to be shared at some point with third parties so that third parties can tailor the ads based on your profile – let’s not be naïve here).
The real reason I left was that my newsfeed had turned into an endless stream of auto-playing videos. Most of those were either ads or BuzzFeed like videos. Meanwhile, my friends were no longer sharing content and had become passive consumers on the platform. I found that I had more time to myself as a result, although I lost touch with some friends with whom I could only connect through the platform.
While I no longer log in to Facebook, I have kept a close eye on its stock price and I did not miss the nearly 20% drop that we all witnessed last Thursday. The drop was the biggest single-day market capitalization wipe-out in US history: $120 billion, gone. I always thought that I was one of the outliers (with a few other friends) for leaving the social network but based on comments made by David Wehner, Chief Financial Officer of Facebook, it looks that this is becoming a trend in Europe. Indeed, in prepared remarks during the Q2 conference call, David Wehner noted that monthly active users and daily active users in Europe “were both down slightly quarter-over-quarter.” Is this the beginning of something bigger?
Beyond the large drop in market capitalization, here are a few things that are noteworthy.
Lesson #1 – Facebook was a crowded trade and we are back at the stock price of early May 2018. So not that long ago.
Facebook’s stock price closed at $217.5 on 25 July 2018 and closed at $176.26 on 26 July 2018. That is a massive drop. If you don’t believe me, please check out the chart below:
If you held shares, your holdings lost approximately 20% of their value. If you held options expiring a month out, those have probably expired worthless, or are about to. That should be a 90% to 100% loss of the value of your holdings. Sure, it also depends when you bought it. Here, I am assuming that you bought in during the month of July to play Facebook’s earnings.
A lot of newspapers and websites covered the drop extensively. They commented at length on the reasons for the drop. They also pointed out how much of a hit Mark Zuckerberg’s net worth took (the estimate is $16 billion dollars if you wondered). Few, however, looked back at the stock price.
The chart below shows the progression of Facebook’s stock price in the last 6 months.
Even after this 20% drop, Facebook’s stock price is back at the levels it used to be early May, which was less than three months ago. Hindsight makes everything easy so I am not trying to tell you that I knew that it would drop. Instead, we now know that the stock price is still above the levels where it hovered during the Cambridge Analytica meltdown. It is fair to say that any stock that grows up by 20% in less than three months may turn out to be a crowded trade – short of some game-changing announcement. If you bought during the April dip, you actually still haven’t lost any money. Sure you lost some unrealized gains, but that’s still a gain. If you were playing options and held through earnings, that’s another story.
In the end, the market brutally corrected itself. The assumption was that Facebook would grow forever. The Q2 results showed that this may not be true. It is bad but it is not the end of the world. And as it turns out, you may not have lost any cash depending on when you got in the stock.
Put things into perspective. On May 14, 2012, Facebook’s stock price was at $38.32. This trade has been incredibly good to long-term investors.
Lesson #2 – If playing options, only put money you are ready to lose
Here, I am distinguishing between options and common stock (shares). The nature of shares is such that you can hold forever (or until the company goes bankrupt). If you believe that Facebook will be back at $200 by the end of the year: don’t sell. If you have cash left, buy the dip. To be clear, I am not advising you to double down. In fact, I would sit this one out until the end of the summer and wait for the dust to settle. You may not buy at the bottom but it is still a better option than trying to catch a falling knife.
With options, there are other variables at play such as volatility and theta. The point is that you cannot hold forever. If you hold long enough, you will suffer from decay. If you buy just before earnings, watch out for that IV crush. If at expiration, the stock price is below the strike price, your options are worth nothing. If they are above the strike price, then good, they are worth something. But then you might get assigned those shares so watch out for that margin call if you don’t have enough available cash in your brokerage account. Still following?
As options are incredibly riskier, you should only buy options with money you are ready to lose. If you don’t have any YOLO money to waste, at least make sure that the expiration date is a couple of months out at least. This will reduce the immediate (negative) side effects of theta.
Lesson #3 – It is incredibly hard to go against sentiment, even for a crowded trade.
Sentiment could be translated as the atmosphere surrounding a stock. A positive sentiment – also known as momentum – tends to result in a higher stock price. In other words, rising stock prices mean that there is a bullish sentiment. In the end, market sentiment can be viewed as the tone of the market.
There are entire strategies built around “market sentiment” and “momentum investing.” I put those two in the same basket but many people will disagree. Momentum strategy, for instance, aims at capitalizing on the continuance of existing market trends.
One “sentiment indicator” is volume. If there is higher than average volume, then one can conclude that there is strong interest in a given stock. If the stock goes up over an extended timeframe, then there is a trend that the sentiment is bullish.
Another indicator that I personally like is Reddit or another similar online forum. People tend to be very honest about their opinions behind the anonymity of a randomly selected username. They will give you their unfiltered view on anything, and this includes stocks. Sometimes, they may even upload a screenshot of their positions.
A couple of days before the Facebook earnings call, I was browsing certain chat rooms and threads on Reddit. The vast majority of people were long because they were hoping for a repeat of the Q1 results, where Facebook posted strong results in the midst of the Cambridge Analytica debacle. I assume the reasoning was somewhat along the lines of: “Facebook’s growth was strong when the press and politicians were beating down the company, things have calmed down since, nothing stands in the way of a strong Q2.”
I remember being surprised by the tone. It was not “Facebook may do well”, but “Facebook will crush again.” This was a reasonable hypothesis given the track record of the stock and the company. But it still made me uncomfortable. So I decided to throw $181 in a put option expiring on 27 July:
I bought one put option contract (100 shares) for $181 dollars. A day later, I sold the same contract for $2,920. That’s a 1,500% increase. Not bad for barely a day of work.
I would love to tell you that it was all planned. That I studied Facebook’s financials for hours. That I spoke to users about how often they used the product. That I found metrics online on how often the site was being pinged every day by region. That I had anticipated the GDPR effect before anyone else.
Of course, none of this is true. It was mostly luck. In fact, I was convinced that I would lose that money. Even losing such a small amount annoyed me as everybody else was convinced that Facebook would outperform and it seemed a sure trade. The only two reasons I still placed that bet (no other name to call this trade) was (1) the chatter pointed to a crowded trade and (2) this was also an imperfect hedge against my MU call options (which are not doing so well at the time of this writing).
This contrarian trade paid off, and of course, I wished I had put my entire net worth in retrospect. But sometimes, it’s good to just be content. If you have a hunch that something is not right but cannot prove it, put a sum that you are ready to lose. You will very likely lose your money but at least you won’t have any regrets. And if you are right, the returns are generally very (very) high.
Key takeaways:
- For long-term passive investors, that 20% drop was not that bad;
- If you play options, (i) only invest money you can lose and (ii) make sure that the expiry is a couple of months out;
- Contrarian trades are the most profitable but are hard to find: invest a small amount at the beginning and avoid the regrets.
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