I’ve rarely seen a market buy a stock with such conviction and in as short a period as they recently did Baidu Inc (ADR) (NASDAQ:BIDU).
At the end of June, investors flipped the buy switch on BIDU stock in a monster way and never looked back. The stock is up roughly 40% in one quarter, most of which came in late July around the earnings event. Management told us that they will over deliver on their promises. Wall Street listened and dramatically readjusted their valuations of BIDU stock. Shorting this rally has been financial suicide to those who dared.
While watching a stock rise this much and this fast is exciting, it makes it very difficult to trade. At this rate, it perpetually looks like it’s ready to correct. Most traders now hesitate to enter a bullish trade fearing being late to the party.
Trading options allows me to chase a stock this hot with relative confidence. Instead of buying Baidu stock outright and risking with no safety net, I use options to set a bullish trade that has room for error.
Key to my strategy is the fact that I don’t mind owning shares of BIDU at a discount. This is to say that if price goes against my trade I will have the opportunity to buy the shares at a much cheaper price.
So finding the proper support from my trades are also key. I seek support levels that are significant enough to withstand short term tests. In this case, there is a clear line in the sand just under $195 per share for BIDU. That area served at the neckline for about 30% points of this massive rally.
Click to Enlarge It is highly unlikely that management will disappoint Wall Street after such a declaration of strength. This is to say that without a massive negative headlines the stock should be able to retain most of the rally through early 2018.
I have to knowledge of the risk of over-inflated expectations in Baidu stock. It is currently trading above the average price target on Wall Street with a lot more room below than above the range set by analysts. Most experts agree that it’s a buy, so the risk of disappointment is high. One year ago 17 analysts rated it as a sell. Today it’s just three.
From a valuation perspective, BIDU is not cheap. Its 52 price-to-earnings ratio is 30% higher than Facebook Inc (NASDAQ:FB) and Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL), and 40% higher than Microsoft Corporation (NASDAQ:MSFT). It is comforting that the company is confident they can deliver, but I also have to weigh the over-zealousness that could be the stock today.
Nevertheless I am confident that I can build a big enough buffer that would withstand a small trip-up in the stock from these levels.
BIDU Stock Trade Idea
The Bet: Sell BIDU Jan $190 put and collect $1.70 per contract. Here I have an 85% chance of success. But if the price falls below my strike I have to own the shares and I could accrue losses below $188.30.
Not all investors are comfortable selling naked puts, especially on a stock with a three-digit price tag. To mitigate some of the risk, they can sell a spread instead.
The Alternate Bet: Sell Jan BIDU $200/$195 credit put spread where I have about the same odds of winning and the spread would yield 10% on risk.
Compare that was risking almost $250 per share and with no safety net expect a rally in order to profit. BIDU stock would need to reach $273 just to match the performance of the spread.
The monthly chart shows the possibility of another leg higher similar to the one that started back in 2013 which brought upon another 50% from a similar double top situation that we could have brewing here.
Investing is risky so I never bet more than I 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 as @racernic on twitter and stocktwits.
