Alibaba Group Holding Ltd (NYSE:BABA) stock is the opposite of a falling knife. Call it a shooting star. It is having an incredible year — up 80% — and shows no signs of slowing down. Sooner or later, markets will correct; but in the absence of disaster headlines, the market and BABA stock has more room to go up.
I am not to buy and hope this happens, however, especially going into earnings. Instead, I want to sell puts in BABA to generate income from this bullish wave. Using options allows me to build a little buffer just in case my timing is not optimal.
Fundamentally, Alibaba is not cheap. From a price-earnings basis, it’s more expensive than Microsoft Corporation (NASDAQ:MSFT) and Alphabet Inc (NASDAQ:GOOGL) combined. It runs a little better margins, but not enough to justify the premium. Perhaps markets are pricing in the bullish comments from BABA management promising better things to come.
Chasing BABA stock at all-time highs seems risky, but technically it’s showing no weaknesses. It is setting higher lows and busting through ceilings for weeks on end. This creates technical vulnerabilities from rising wedges, but I can manage my risk in options as long as I can sell my risk below support. I also have to account for a potential letdown in expectations, which are lofty. One hint of trouble could be met with selling.
BABA Stock Options
Click to Enlarge The problem with momentum stocks like BABA is that they don’t leave many obvious entry points. On the way up they seem like they are due for a pullback. On the way down they appear to be falling knives into abysses. Using options helps me slow the action down a bit to minimize the need to be surgical with timing.
The Bet: Sell the Oct BABA stock $130 put and collect $1.20 per contract. Here I have a 90% theoretical chance that price will stay above my strike so I can earn maximum gains. Otherwise, I will accrue losses below $128.80.
To mitigate the risk from selling naked puts, I sell spreads instead.
The Alternate Bet: Sell the Oct BABA stock $130/$125 credit put spread where I have about the same odds of success less the huge risk. Yet if the spread wins it delivers roughly 10% in yield.
In either case, I built a 17% buffer room for error. I like that especially going into earnings. Compare that with risking $158.50 here to buy the BABA shares and, with no room for error, expecting a 10% rally.
Investing in options is risky business, so don’t ever risk more than you can afford to lose.
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.