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Disclosure: This post is intended for educational purposes only. Options may not be suitable for all investors.
What happens if you want to own a stock but are worried about short-term volatility? Use options — that seemed to be the answer from a big investor yesterday.
The name in question was Alibaba (BABA), which has struggled recently amid global trade disputes. Still, the Chinese e-commerce giant has trended higher for more than a year and has a potential catalyst in quarterly earnings on August 23. What if sentiment turns bullish again?
Instead of jeopardizing large amounts of capital to own shares, traders can can use calls to manage risk while at the same time ensuring they won’t miss a rally. Here’s what we saw yesterday in BABA:
They paid a net $4.15 and lowered the bar for making a profit. Overall the transaction cost $12.45 million because each contract controls 100 shares. But a lot more is going on…
Making the adjustment increased their delta, or the amount their position will track the underlying stock. In this case they swapped contracts with 0.38 of delta for contracts with 0.53 of delta. That means their new position will perform like owning 1.56 million BABA shares rather than 1.14.
The strategy has two major benefits:
First, owning 1.56 million BABA shares would cost more than $270 million. With calls they’re risking less than 10 percent of that amount for the same exposure.
Second, calls have gamma — or the tendency to increase in delta (leverage) if a rally occurs. Those 30,000 contracts may now represent 1.56 million shares, but they can potentially increase to the equivalent of 3 million shares. BABA simply has to close over the strike price. See our Knowledge Center for more.
BABA ended the session down 1.23 percent at $178.62 — pretty close to that $180 level.
In conclusion, many people view options as risky products. But in this case an investor is using them for the very purpose of managing risk.
Alibaba (BABA) chart with strike prices involved in yesterday’s call roll.
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