Almost Everyone Is Bullish On Alibaba. What If We’re Wrong? – Alibaba Group Holding Limited (NYSE:BABA)

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Bloomberg’s Emma Chandra Reporting On Alibaba

(Almost) Everybody Loves Alibaba

On Bloomberg TV’s “What’d You Miss?” on Tuesday (full video here), Emma Chandra and Julie Hyman noted that, other than short sellers (such as Jim Chanos) everyone loves Alibaba (BABA): 94% of Wall Street analysts have “buy” ratings on the stock, and the other 6% are “holds”. We’ve been bullish on BABA too, but with the stock hitting one record high after another, we thought it would be prudent to present an updated hedge on it. First, let’s look at how it’s done since it hit the Bulletproof Investing top-10 on June 22nd.

Our Top Ten Names Two Months Ago

Every trading day, our Portfolio Armor website runs two screens to weed out bad investments on the 3,400+ securities with options traded on them in the U.S. Then, it estimates potential returns over the next 6 months for each of the survivors, and ranks them by potential return, net of hedging cost. Once a week, we share the top-10 names from that screen with our Bulletproof Investing subscribers.

On June 22nd, Alibaba was our top-ranked name. It’s up 23.5% since then. To avoid accusations of cherry-picking, below is a graph showing the performance of all of our top-10 names from June 22nd.

The only stock there to outperform BABA was another Chinese stock, TAL Education Group (TAL). Our system is still bullish on BABA, but as you can see above, we’ve had a few losers so far from our June 22nd cohort, including one double-digit decliner, NetEase (NTES). This is why we generally suggest investors consider hedging when holding any our top picks. We’ll look at a couple of updated ways of hedging Alibaba below.

Hedging Your Bet On BABA

Here are a few ways of hedging 1,000 shares of BABA against a greater-than-15% decline by mid-January. First, a reminder: you hedge when you are bullish on a security and think it will go up; if you’re bearish, you should sell your shares.

Uncapped Upside, Higher Cost

These were the optimal, or least expensive, put options to hedge BABA against a >15% drop by mid-January. For investors with this risk tolerance, this was Portfolio Armor’s preferred hedge for portfolio construction purposes. We’ll explain why below.

As you can see above, the cost (calculated conservatively, using the ask price of the puts) was $5,200, or 2.96% of position value.

Capped Upside, Slightly Lower Cost

Portfolio Armor estimates a potential return of about 33% for BABA between now and mid-January. This was the optimal collar, as of Wednesday’s close, to hedge BABA against a greater-than-15% decline while not capping your possible upside at less than 33% by then.

As you can see above, this hedge used the same put leg, but the short call leg offset some of the cost. So the net cost was a bit lower: $4,410, or 2.51% of position value.

We mentioned above that our system preferred the first hedge for portfolio construction purposes. Here’s why. In our tests, securities hedged with puts have gross returns (not net of hedging costs) more than a third higher than those hedged with collars, on average. This is due to the effect of positive outliers. So, our system adjusts the potential returns of securities hedged with puts up accordingly. Then it subtracts the hedging cost, and compares that net potential return with the net potential return of the same security hedged with an optimal collar. If the hedging costs are relatively close, as in this example, our system goes with the put hedge.

Conclusion

The hedges above are two examples — BABA longs with different risk tolerances can try using different parameters. Using the same hedging tool, we were able to find an optimal collar with a 13% cap at the same 15% decline threshold that had a negative cost. We haven’t presented that here because we suspect that few BABA longs would be willing to cap their potential upside at 13% over the next several months, but if we’re wrong about that, let us know in the comments, and we can present a negative cost hedge in a follow up article.

Disclosure: The author have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article himself/herself, and it expresses author’s own opinions. The author is not receiving compensation for it. The author have no business relationship with any company whose stock is mentioned in this article.

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