A very friendly bullish pattern is setting up again in China-based tech giant Alibaba Group Holding Ltd (NYSE:BABA). But to avoid the potential hazard of being set up, a bullish modified butterfly strategy looks like a better way to ride BABA stock. Let me explain.
Alibaba — or as I like to say, Asia’s Amazon.com, Inc. (NASDAQ:AMZN) — has been on a tear in recent months since breaking out of a massive corrective base that was more than two-and-one-half years in the making. In fact, shares are up about 45% in just over four months out of the pattern.
To be sure, it has been a very nice rally for BABA stock bulls. It has also been a price trend that has allowed this strategist to take consistent profits. Most recently, in front of earnings I detailed reasons for buying a well-placed bull call spread that’s now on the verge of capturing nearly 450% and over $8 in profits.
Can you say “K-A-A-C-H-H-I-N-G-G!!?” I certainly hope so. And guess what? Following a terrific earnings report last month, BABA stock is in position for another repeat performance if recent history can at least rhyme. And while Jim Chanos of short-seller Kynikos Associates may be shaking his head in disbelief, in our estimation, the Alibaba chart looks well-supported to make good on that bullish promise.
Alibaba Weekly Chart
The trend remains a friend for BABA stock bulls. As noted above, since breaking out of a massive corrective base in May, shares have been rallying strongly.
That price strength has manifested itself into a favored momentum situation, as traders wanting to buy BABA on a pullback have collectively been forced to chase shares higher instead.
Now and in digesting last month’s bullish reaction to earnings, shares of Alibaba are once more setting up on the price chart. The name for the pattern is typically called a short or tight flat base and is generally associated with momentum stocks like BABA.
This is the third occasion for this type base to form in Alibaba since May’s enthusiastic trend shift. So, will the third time prove as charming for today’s bulls as well? This strategist believes it will.
Supporting a long position in BABA stock, third bases are typically buyable without having to fear bulls have overstayed their welcome. Sure, gains of around 45% in four-plus months are nothing to sneeze at. However, given the size of the former weekly base, it’s definitely less worrisome.
Lastly, a fairly supportive stochastics indicator and decent, but not over-the-top price momentum as shares of Alibaba run along the upper Bollinger Band — continues to promote the good kind of setup for BABA bulls in this strategist’s view.
BABA Stock Bullish Modified Butterfly Spread
Given our bullish view that BABA stock will continue to rally, but willing to counter some of our enthusiasm due largely to bearish seasonal factors, a bullish, modified long call butterfly looks promising. With shares of BABA at $174, one favored combination of this type is the Oct $175/$185/$190 call butterfly for $2.70.
As with a traditional long butterfly, below the lowest $175 strike the spread will collapse to $0 at expiration. That’s the equivalent of 1.50% of BABA stock risk and fairly reasonable. At the end of the day, the bullish trend has been very durable and we see it as continuing higher. However, decent protection from the possibility of less-friendly behavior, is nice to have in place and this butterfly offers just that sort of assurance.
What’s also nice is that the spread begins to breakeven at expiration if BABA stock musters up a fairly modest rally of 2%. If shares can rally by 6% to $185, the butterfly would capture its max profit of $7.30 for a return of 270%. Nice.
Even more attractive, should additional chasing by investors push Alibaba above the spread’s highest strike at $190, unlike a regular butterfly, the modified won’t lose money. This particular combination still takes in $2.30 no matter how high BABA is above the spread due to the varying and favorable construction of the embedded verticals.
Investment accounts under Christopher Tyler’s management do not currently own positions in any securities mentioned in this article. The information offered is based upon Christopher Tyler’s observations and strictly intended for educational purposes only; the use of which is the responsibility of the individual. . For additional market insights and related musings, follow Chris on Twitter @Options_CAT and StockTwits and feel free to click here to learn more about how to design better positions using options!
