At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out businesses with a strong balance of current competitive dominance and future growth potential. Among all the companies I follow, Facebook (META 1.70%) has one of the best combinations of a powerful, competitive moat and massive long-term growth opportunities. So much so, that I will be making Facebook one of the largest positions in Tier 1.
Facebook is a classic Rule Breaker that is fundamentally changing the way people interact and connect with each other. Impressively, it also displays many of the characteristics of a Rule Maker, as its network of more than 1.3 billion monthly active users dwarfs that of its competitors, and has made gaining access to its platform a requirement for advertisers worldwide.
I want to increase Tier 1's ability to profit alongside Facebook, but I want to do so in a more conservative manner than simply buying shares. That's because while I'm excited about Facebook's long-term potential, the next 12 months could be somewhat volatile. Management has stated that they expect 2015 to be "a significant investment year" with expenses "likely to increase 55%-75% compared to the full year 2014." Although that outlook is now likely to be at least partially priced into Facebook's share price, should the company's expenses come in at the high side of that range, Facebook's stock could underperform in 2015. With Facebook's shares currently trading near all-time highs -- as well as the market as a whole -- I'm willing to trade some upside in order to gain some downside protection.
To do so, I will be selling puts on Facebook. With this option strategy, I will be paid a premium to enter a contract to buy 100 shares of Facebook at a specified time and price. Specifically, I will be selling the Facebook January 2016 $80 puts, currently trading at about $10 per share. If Facebook is trading at or above $80 on the Jan. 15, 2016, expiration date, the puts will expire worthless. And the $1,000 I receive in premium ($10 per share times 100 shares) will amount to a 12.5% gain on the $8,000 at risk ($80 per share times 100 shares).
If Facebook is trading below $80, I will be obligated to purchase shares at an adjusted price of $70 ($80 strike price minus the $10 per share in premium), or about 12.5% lower than today's $80.02 price. I think it's also important to note that I would be buying Facebook in January 2016, after the company will have had time to grow its earnings and cash flow significantly. So, in effect, I would be buying shares of the social media king at a better valuation than is possible by simply buying shares today. And, importantly, I'd be very happy to purchase Facebook's shares at that adjusted $70 price.