Buying Twitter Without a Roll Cage

NEW YORK (TheStreet) -- If you haven't paid attention to Twitter's (TWTR) stock price lately, you're missing a spectacle. The last time I witnessed mindless price action like this was during the BP (BP) gulf spill. All stocks are influenced by emotion, that's expected, but Twitter wins the medal for most extreme of 2013, hands down.

For the active trader, Twitter is the perfect stock. Extreme volatility combined with massive volume can only result in one outcome, an efficient speedy transfer of wealth from the dumb money to the smart money. Some will say the valuation is out of line and oxygen is required because the current valuation places the blue bird above T-Mobile (TMUS), Dish Network (DISH) and Corning (GLW).

[Read: Jim Cramer: Ride the Four Horsemen of Biotech]

Having a market cap greater than other technology companies may not be fascinating on its own; however, Twitter is the only one of the group that isn't expected to post a profit next year. If Twitter does manage to post a profit in 2014, or the next, the price-to-earnings ratio will be at least in the triple digits. To put a triple-digit P/E ratio into context, a ratio above 20 is historically expensive in the long run.

The odds of buying a multi-billion dollar market cap stock with a P/E above 100 and profiting after holding for much more than a day-trade quickly approaches zero as the P/E increases. For most Twitter traders, it doesn't matter because they don't intend to hold for days, much less months. Since Twitter's share price is apparently fueled by speculation and emotion right now, a trader can get long or short and profit.

By using options instead of buying stock directly, investors can limit the level of exposure while avoid becoming the next stop-loss roadkill victim.

If you don't look at charts all day, every day, you may have to take my word for it, but Twitter's running of stop losses were so predictable in the last few days that some of my trading revolved around it. For example, near the end of the day, the price dropped from approaching $64 a share to close at $60.51. At each price level, shares dipped below and then exceeded the level before continuing lower. As an active trader, I could buy the dip below and close out just above the level. The same could be done in reverse on the way up.

Not everyone that wants to participate has the luxury of staring at green and red bars on monitors all day. This is where options come into play. But, you can buy options and expect to profit, unless you're intraday trading. The day after Christmas, option volatility was increasing so fast that put options increased in price at the same time shares were appreciating.

Remember, put options give you the right but not an obligation to sell shares. Normally, when a stock is rising, call options increase, and put options decrease, all else being equal. Not all was equal though, and both calls and puts were increasing in price at the same time. While the underlying stock price is a significant influence on option pricing, it's not the only one. Implied volatility, along with supply and demand, greatly influences the price of an option. Demand for Twitter options increased faster than supply, causing the price to skyrocket.

[Read: Five Common Items You'll Pay More for in 2014]

The premium has come down, but is still high enough that I'm writing premium to gain an edge. You can do the same, regardless if you believe the shares will rise or fall. Instead of buying either a call option or a put option, you should consider a strategy known as a spread. I prefer credit spreads (collecting more premium than I buy) in order to gain time decay. For example, an investor that believes Twitter is offering a buying dip can buy a January $55 put option for about $2.40 and at the same time sell a January $60 put option for about $4.70, for a net credit of $2.30.

Yes, the most profit to be made is $2.30, but the amount of risk is lower. If Twitter plummets to $40 a share, the maximum loss is $2.70. In fact, as long as the shares are above $60 on expiration day, the full $2.30 in profit is realized. Using credit spreads, I first shorted Twitter, and now I'm using covered calls to become net long.

At the time of publication, Weinstein had no positions in securities mentioned.

Follow @RobertWeinstein

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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