Alexander Valtsev
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Sell Alibaba's Options' Volatility Next Week

Alibaba's (BABA) shares are up by high singles on high volume today pushed by inertia of the earnings release yesterday:

Despite that, the implied volatility in the stock's options is still quite high after having lost some value just by an inch:


Note the spike pre-earnings: the level of implied volatility is still quite high, even though there is only five business days left before expiration.

In my opinion, the spike in the stock's price can be exploited by an options strategy called a vertical spread. Essentially, investors buy or sell at-the-money call options and partially fund the trade or hedge the exposure by selling or buying out-of-money calls:

(Source: TD Waterhouse)

I personally recommend going short with the call spread: that is, selling the at-the-money options, which have a monstrous theta decay in the last week of their life, and buying out-of-money calls for hedging purposes for a nice upfront premium. Here is what the trade looks like:


The risk-return ratio of this trade is quite attractive for this type of strategies:


As you can see, the risk-return ratio is around 1:0.5. However, the #1 reason why I like this particular trade is not its risk-return ratio or the upfront premium by the high probability of success of this trade:

(Source: Google Finance. Calculations by author)

As you can see (look at the value of the Delta), there is only a 39% chance of an option with a strike of $99.30 (effectively, the break-even stock price for our strategy) to get into the in-the-money region. This means that there is a 61%+ chance of success in this trade. Ideally, one would aim for a 70%+ chance of success but I think, given the risk-return ratio, that this probability will do. In my opinion, the stock will correct itself next week starting Monday, and we will see a modest sell-off from the rally. If we are wrong, however, the loss is quite small in both absolute and relative senses.  

What do you think of this trade?