Alibaba Group Holding Ltd (NYSE:BABA) certainly is off to a flying start in 2017, rising over 25% so far this year. BABA stock broke out past the critical $110 resistance area yesterday and looks poised to attack the all-time highs at the $120 level. Analysts are universally bullish. Nothing can seemingly stand in the way of big bad BABA.
Except for valuation.
Given the extremely rich valuation of BABA stock at current levels, I expect Alibaba to consolidate around the $110 level in front of earnings.
In my previous post on Alibaba, I expected a breakout from the $105 level in BABA given the consolidating price action and low option implied volatility. Now that Alibaba stock has broken out sharply and implied volatility has risen, I look for a reversal and a new period of consolidation to ensue.
BABA now sports a very lofty 50.8 P/E, twice that of the S&P 500. The multiple is also well above the five-year average P/E of 30.
The last time Alibaba had such a rich valuation proved to be a significant intermediate-term top in the stock.
Click to Enlarge Alibaba has also been a huge outperformer to the Nasdaq 100, more than doubling the comparative return. The last time BABA got this far ahead of the Nasdaq proved to be an opportune time to take a short position in Alibaba.
I expect BABA stock to converge and be a relative underperformer to the overall market over the coming months.
Alibaba is now the ninth-largest stock by market cap in the S&P 500, so future growth will be more difficult simply by the law of large numbers.
Click to Enlarge So with BABA stock now overly extended on both a technical and fundamental basis, a period of consolidation is likely on the horizon. Implied volatility has risen sharply to the 50th percentile over the past few weeks, making option selling strategies viable. Selling an out-of-the-money call spread is the optimal trade structure to take a guardedly bearish-to-neutral stance.
BABA Stock Trade Idea
Buy BABA 28 Apr $117 calls and sell BABA 28 Apr $115 calls for a 45-cent net credit or better.
Maximum gain on the trade is $45 with a maximum loss of $155 per spread. Return on risk is 29%.
The short $115 strike price provides a 3% upside cushion to the $111.70 Monday closing price of Alibaba. The April 28 expiration is before the earnings date of May 4 to avoid any earnings-related risk.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at tbiggam@deltaderivatives.com.
