How to Invest in Alibaba As Shares Keep Rising

Nov. 10, 2014 8:59 p.m. ET

Tuesday, Singles Day, is the biggest day of the year for sales at Alibaba, but buyers have been snatching up shares of the e-commerce giant ever since its initial public offering.

Rather than declining after its offering, which is what happens to most stocks when Wall Streets IPO marketing machine quiets, Alibabas ( BABA BABA -3.869072597566093% Alibaba Group Holding Ltd. ADS U.S.: NYSE USD114.54 -4.61 -3.869072597566093% /Date(1415743238187-0600)/ Volume (Delayed 15m) : 70698764 AFTER HOURS USD114.98 0.44 0.38414527675921073% Volume (Delayed 15m) : 453654 P/E Ratio 41.4249547920434 Market Cap 296169646064.458 Dividend Yield N/A Rev. per Employee 628829 More quote details and news ) stock keeps rising. This is not insignificant. Many investors actively position for post-IPO declines, especially on companies that trade at about 60 times estimated current-year earnings.

But Alibaba the U.S. stock markets equivalent of Chinas rare and expensive Da Hong Pao tea is the exception to the rule. The companys first earnings report was so good that analysts sharply increased price targets. Cantor Fitzgeralds Youssef Squall exclaimed his enthusiasm for Alibaba shares with a concentration of bullish buzzwords.

A differentiated pricing model, strong brand and unmatched scale continue to give Alibaba an unfair competitive advantage relative to peers both in and outside China, he wrote. We believe the companys outsized growth and margin profiles should support higher valuation over time.

Squall is not alone in his praise. Stock analysts are raising Alibabas price targets well above the stocks recent $109. This reflects widespread expectations that Alibaba will continue to mint money. In the options market, investors are buying some calls that indicate they believe Alibaba will rise above $130 by January. The stock was recently around $117.

Without getting lost in financial models and assumptions analysts are making about Alibabas growth, consider that the shares are up about 70% over the mid-Septembers stock offering (or 25% over the opening-day close), even as investors consider re-pricing Chinas risk.

The primary proxy of Chinese stocks, the iShares FTSE/Xinhua China 25 Index, has largely declined since Sept. 8. The exchange-traded fund is now below $40, a psychological level that seems to cause investors to wonder if Chinas markets are about to fall further.

Jared Woodard, a BCG Partners derivatives strategist, recently advised clients that the cost of hedging Chinese stocks is rising. Chinas electricity production is declining, indicating slower economic growth. Other worrisome signs include slowing land sales and reduced shipping container volume, and also pressures on Chinese banks from bad loans.

Meanwhile, it seems every Wall Street analyst is telling clients to buy Alibaba. This kind of enthusiasm often precedes stock declines because investors tend to go all in, anticipating a big rally. In the absence of more buyers, stocks decline.

With the stock at $117, investors can consider taking profits by selling March $110 puts. The puts were bid at $8.80 and priced with an implied volatility of 42.4%. The volatility level indicates the options market thinks the stock will move 2.65%, up or down, each day until expiration. (The expected move is revealed by dividing 42.4% implied volatility by 16, which is the square root of the annual number of trading days.)

If the stock does not decline below the $110 strike price, investors can keep the $8.80 put premium. Should the stock trade below $110 at expiration, investors are obligated to buy the stock.

The put sale is a bullish way to harvest profits. The money received for the put is significant, relative to most options prices. Only consider this trade, however, if you agree with two key assumptions: The first is that Alibabas declines will be short and shallow and unlikely to fall far below the put strike price. The other assumption is that investors, including those who have missed out on Alibaba, will buy the stock should it experience a meaningful decline.

To be sure, selling puts is a very aggressive, bullish trade.

To reduce risk, a more traditional approach is to sell enough stock to cover your the initial investment. If you invested $100,000, and have made about $50,000, sell enough stock to take out your money. To maintain the positions size, buy a long-dated call. The call costs far less money than the associated stock, and it will increase in value should Alibabas stock rally higher as so many Wall Street banks are predicting. The January $120 call that expires in 2016 was recently priced at $20.80 with an implied volatility of 43.7%.

The recommended trading strategies are intended to balance Alibabas stock-specific risk against caution signals many investors see emanating from Chinas economy. Reducing risk may prove premature, but there is one thing that all successful investors have in common: They always think about how much money they have at risk.

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