A recurring theme this year has been bad news from China. First, and most obviously, the new coronavirus; then materials sent by China to other countries to fight the virus. For example, last week, Pakistan received what it expected to be N-95 masks from China, only to find out that they were masks in underwear.
China has not done its best
Letters, conferences and more on Q1 2020 hedge funds
The bad news from China also included revelations of fraud at Luckin Coffee (LK) and TAL Education Group (TAL). As Tim Knight, market technician and hedge fund manager recently pointed out, this raises questions about the confidence that investors can have in Chinese accounting in general.
– 𝕊𝕝𝕠𝕡𝕖 𝕠𝕗 ℍ𝕠𝕡𝕖 – Let ‘Em Burn (@SlopeOfHope) April 7, 2020
Indeed, the recent news on Luckin Coffee and TAL Education should make the shareholders of Alibaba Group Holding Ltd (NYSE: BABA) think. Jim Chanos, who recently covered his short film on Luckin Coffee, suggested earlier this month that investors should avoid Chinese stocks “like the plague”. Readers may remember that Chanos short-circuited Alibaba several years ago and, when he covered his short film, said he was still skeptical about the company’s accounting .
In the event that Chanos’ skepticism about Alibaba – and its recent warning about Chinese stocks – turns out to be prescient, let’s look at a few ways in which those who hold long BABA stocks can limit their risk.
Downside protection for BABA stocks
For these two examples, I have assumed that you hold 500 Alibaba shares and can tolerate a 19% drop in the coming months, but no more than that.
Uncapped upside, positive cost
As of Tuesday’s close, these were the optimal, or cheapest, put options to cover 500 BABA stocks against a drop of more than 19% in mid-October.
Screen capture via Portfolio Armor.
The cost of this protection was $ 3,850, or 3.89% of the value of the position, calculated conservatively, using the sale price of the put options (remember that in practice, you can often buy and sell options at a certain price between supply and demand). This corresponded to an annualized cost of 7.43% of the value of the position.
Amount capped, negative cost
If you were ready to cap your upside potential at 11%, this was the optimal collar to protect you from the same drop of> 19% over the same period.
Screenshots via Portfolio Armor.
Here, the net cost was negative, which means that you would have collected a net credit of $ 875, or 0.88% of the value of the position, assuming that you placed the two transactions at the worst ends of their respective spreads. . This translated into an annualized cost of -1.69% of the value of the position.
Conclusion – Other options
If you are optimistic, and you don’t want to cap your increase, but want to spend less to cover yourself, you can change the expiration of your option to bring it closer and look for the optimal options (keep in mind that your annualized cost may be higher). some of these earlier expiration dates).
If you are bearish, you can sell your BABA shares and buy put options in the first cover as a speculative bet against the company.
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