Alibaba Options: Options Debut Scorecard

Published on: Oct 01 2014 by John Critchley

 

 

 





 

  Alibaba (BABA) options started trading this week on all major exchanges a mere week and a couple days after the much ballyhooed IPO’s smashing debut on the New York Stock Exchange.

    The successful BABA IPO process was in stark contrast to the Facebook IPO NASDAQ listing debacle and may led to more heightened interest in the Chinese E-commerce giant.  With this increased scrutiny comes volatility and with volatility comes trading opportunities.

 

The first few days of trading have been illuminating and interesting in BABA options.

 

Here is a snapshot of what we have observed in the first few days:

 

1) Implied Volatility in the options is around 38.5%.  Many market participants had made estimates that initial implied volatility would be trading anywhere from the mid 40’s to high 60’s.   The implied volatility is definitely trading at the low end of the estimated range.  This is quite surprising and may create an opportunity to pick up some ‘cheap’ options. 

 

As a comparison, Facebook implied volatility was around 58% in the days following the listing the   implied volatility of Chinese Internet stocks Weibo Corp and Baidu Inc were at 60.82 percent and 36.43 percent, respectively

 

2) Volatility skew is only mildly steep. Many market participants expected there to be a severe volatility skew and this expectation has so far not materialized.  The volatility skew between the out-of-the-money puts versus calls has been generally muted at approximately 2.2% which may present a compelling opportunity to buy some ‘cheap’ protection.

What is Volatility Skew?

This means quite simply that the out-of-the-money (OTM) puts trade at a higher implied volatility than at-the-money (ATM) puts and OTM calls. Normally as a stock rises a common strategy that is extremely popular with institutions and public customer is to overwrite (sell) the options against existing underlying equity positions.  The basic theory of supply and demand kicks in and drives the prices lower as the liquidity providers lower the price of the options as the supply increases. Another common query is: Why is the volatility in the out-of-the-money (OTM) puts normally so much higher than the OTM calls?  Part of the explanation was described above, but there are other explanations as well.  In general, large violent moves in stocks have a tendency to be downward in nature.  Whereas, institutions and public customers have a tendency to sell OTM calls in order to bolster return, they will buy puts to protect themselves against unexpected large downward movements in the underlying.  There are of course, instances (takeover rumors, extraordinary upside run-ups in an underlying, development of a breakthrough product like a new drug etc.) where the OTM calls will carry a higher volatility but, in general the fear of the unknown on the downside is much greater.  Investors and traders are much more willing to pay a higher premium for insurance protection, which means implied volatility on OTM puts will normally trade at a higher level than the at- the- money(ATM) puts.  If the sentiment in Facebook ever turns positive and there is a sharp spike in the underlying like we witnessed in AAPL a few months ago, expect the volatility skew to reverse itself and become a smile. A smile occurs when the OTM calls trade at a premium to the OTM puts.  This is very rare, but can happen.

 

3)  Option volume has been good, but not been overwhelming. The pre IPO euphoria has not completely translated in to the trading of BABA options.

Options volume for Alibaba was over 100,000 contracts on the first day and considerably less on subsequent days.  As a comparison, there was over 210,000 FB options traded and the Facebook options broke the options record for a debut listing.   

Interestingly, the bias of option order flow showed bullish and bearish bets nearly evenly distributed in the first few days.

Simply stated, an equal number of calls and puts imply equal numbers of bets on the Alibaba stock climbing or falling from current levels.

 The option marketplace seems to be sending mixed signals as far interpreting order flow bias.  

 

4) The put-call parity in the options is fairly priced.  There was widespread concern that due to the fact quite a few people think the stock is overvalued and want to short the stock that the stock would be impossible to borrow. This turned out not to be the case and any buyer of puts today received a fair price when compared to the price of comparable call strikes.

 Why care about the cost of borrowing BABA?  The simple answer is that it will get priced into the options in the form of Reversals and Conversions and affect the pricing of synthetic options. The increased borrowing costs could have driven up the prices of the puts and also made option conversion prices shoot higher. 

 

5) The option markets are reasonably narrow and appear to be quite fairly priced. The main obligation for market makers is to provide an orderly and liquid marketplace.  The option markets in BABA today are quite liquid and narrow.  It looks like the option market makers did a fine job in creating a fair marketplace in the first few days of trading.

 

Let’s see what the following weeks brings.

 

 

Stay tuned…

 

Disclaimer


We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in  this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

 

 

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