Alibaba’s risk matrix and a way to play it (NYSE:BABA)

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Thesis

Lately, Alibaba (NYSE: BABA) stock prices were dominated by the news and disconnected from the fundamentals of the company. As you can see from the following chart, stock prices have regularly fluctuated in the double digits in a single trading day, which is completely absurd because the business fundamentals of such a large company should not change overnight (let alone change by more than 10%). To cite a few examples, its stock rebounded 14.8% on May 26 when it released its March quarter results and another 14.7% on June 8 when the Chinese government approved video game licenses. Then, on July 11, the stock price fell 9.2% on news that China BABA fined for his filing issues (even though the fine is only a nominal $373,000).

Such a disconnect is certainly frustrating for some investors, especially in the short term. However, as we always remind ourselves and our members, such short-term volatilities only create opportunities for long-term investors. In particular, we see a substantial misvaluation of its valuation and implied volatility caused by the large swings in price. Due to the mispricing of its valuation, you can ignore short-term volatilities and focus only on the long term (a thesis we and most SA bull authors have made).

This article will mainly focus on the second aspect, the mispricing of its implied volatility. And as an action idea, this will show that the current condition presents a good setup for a long call option play in case you want to bet short term with limited risk exposure (in terms of total dollar amount).

We’ll go into mispricing in more detail later. But probably by looking at the price actions against Amazon (AMZN) in the chart below, you can already get a good idea of ​​the extent of the mispricing. AMZN’s stock price has fluctuated in a narrow range of minus 10% and plus 10% for the past three months or so. But BABA’s stock prices regularly change in double digits, as mentioned above. Yet, the options market’s implied volatility for BABA is around 60% for call options expiring in January 2023, only around 33% above AMZN’s 45%. And then we’ll discuss why such implied volatility is a material misvaluation.

Before we dive in, I also want to mention that I co-produced a BABA paper earlier this month with Envision Research. In case you have also seen this article, I wanted to summarize the differences here upfront. In a word, they are completely different. This article focused on the lessons we learned from our BABA investments and our long-term vision (i.e. BABA’s leading position in the e-commerce space). This article focuses on its short-term volatility and the use of the option. This is not only a different angle from my previous article but also different from other recent BABA analyzes that I know of.

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Yahoo Finance

Business insights and catalysts

BABA announced mixed results for its March quarters. On the positive side, it reached 1.3 billion annual active consumers worldwide, a year-on-year growth of 2%. The growth of international users is a highlight with a growth of 13%. Revenues from all of its major segments (Chinese Commerce, International Commerce, Local Consumer Services, Cainiao, and Cloud) all recorded healthy year-over-year growth in the range of 7% to 29%.

On the negative side, the company recorded a net loss of RMB 18.4 billion in GAAP terms. The company suffered an anti-monopoly fine of RMB 18 billion imposed during the March 2021 quarter. Adjusted EBITA also decreased by RMB 6.8 billion to reach RMB 15.8 billion year-on-year. On a non-GAAP basis, the company posted positive revenue of RMB 15.8 billion, down 23% from the year-ago quarter.

More concerning is that the company cited uncertainties with its investments in Taocaicai and Taobao Deals and the impacts of the COVID-induced shutdown. Due to these uncertainties, the company could not provide any forward-looking guidance, as CEO Toby Xu commented below (abbreviated and underlined by me):

Now, in terms of guidance, since mid-March 2022, we have seen a significant impact on our national Resurgence of COVID-19 in China, especially in Shanghai, given the risks and uncertainties related to COVID-19, which we are unable to control and difficult to predict. We think it is prudent at this time not to give financial guidance generally provided at the beginning of the financial year.

Such opacity is generally a bad thing. Investors simply hate opacity. However, as we will see next, due to such opacity, the market does not know how to assess its volatility, which creates an opportunity.

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BABA Earnings Report

Misjudgment of volatility

As mentioned above, if you could ignore these short-term issues and just focus on the long term, there’s nothing wrong with just holding the stock.

However, its volatility mispricing also offers an attractive setup for a long call play. The setup has a few advantages over the buy-and-hold strategy. First, it may limit your exposure in terms of the total dollar amount. Second, it can take advantage of both poor valuation AND volatility (the buy and hold strategy only takes advantage of the former). Third, it provides a definitive expiration date.

As an example, at the time of writing, the BABA call option with a strike price of $105 that expires on 2023-01-20 is selling for around $20, as you can tell. see in the table below. provided by OIC. So $2,000 would provide exposure to 100 shares, versus $10.5,000 if you hold the shares directly.

You can also see that the implied volatility is around 60%. Again, to me, that’s an understatement. That’s only 33% above AMZN’s 45% implied volatility for near-in-the-money calls with the same expiration date. However, as noted earlier, BABA stock price movements can be 5 to 10 times AMZN price movements.

Implied volatility is also significantly lower than BABA’s historical volatility, as you can see in the second chart below. Its historical volatilities have been near or above 100% for long periods of time and are currently around 83%.

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Source: oic.ivolatility.com

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Source: oic.ivolatility.com

Final thoughts and risks

Furthermore, there could be several catalysts in the new future (before January 20, 2023) that could trigger large price movements in either direction. The call is inherently asymmetric, so the downside is limited but the upside is not. The upcoming June quarter earnings report is one such catalyst. The opacity of the March results calls opens the way to surprises. The next big catalyst involves the relaunch of its Ant Group IPO. His price actions on the day the Bloomberg report announced the news is another example of the market underestimating its volatility.

And finally, the risks. The risks surrounding BABA have already been discussed at length by other SA authors and ourselves (VIE, the “China” risk, competition, et al). We won’t repeat them here and just want to point out that a call option is a way to limit these risks. Although we would like to point out the risks involved in using call options themselves. Options can limit risks in terms of absolute dollar amount. But it’s more risky in relative terms. You can lose 100% and there are actually good chances for that.

About Florence L. Silvia

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