The Alibaba (BABA) IPO

Talk of the Town: The Alibaba (BABA) IPO
Options Traders are Watching Yahoo! (YHOO)
Volatility YHOO Option Trades

The talk of the investing community is tomorrow’s initial public offering of Alibaba Group Holdings (BABA). The Chinese online e-commerce giant recently raised the price range to be between 66 and 68 a share, which could make it the largest IPO to list on an American stock exchange.

While many will be watching to see if BABA will make a dramatic move lower or higher once the stock opens for trading, options traders are focused on Yahoo! (YHOO).

YHOO’s stock is up well over 100% in the last two years, at least partially because of its 22% ownership in Alibaba. Because of this ownership stake, YHOO could see significant volatility based on Alibaba’s IPO.

The implied volatility, or price of options, for YHOO heading into this IPO is off-the-charts high. While the stock typically moves at a volatility of around 25, the options market is pricing the options at around 58 volatility. What does this mean? Essentially, the prices of the options are more than double what they should be.

What makes the options pricing so interesting is that while volatility/price of options is high, the options that seem grossly overpriced are the far out-of-the-money puts and to an even greater degree, the far out-of-the-money calls. Out-of-the-money means that these puts and calls would expire worthless if the stock were to close at the current price on the options’ expirations.

These YHOO puts and calls are priced almost like options for a biotech company that’s about to release important clinical data that could make or break the company.

For example, with the stock trading at 42.25, YHOO September 38 Puts that expire on Friday are currently 0.10 bid. That means the stock will have to drop 10% by the close on Friday for the puts not to expire worthless.

Conversely, the YHOO September 46 Calls, also 10% out-of-the-money are 0.28 bid—a truly astounding price.To find a call that is the same price as the September 38 puts I mentioned above, we would have to go 16% out-of-the-money and look at the September 49 calls which are 0.10 bid. Essentially, the market is pricing in “tail risk,” or extreme risk, to the upside.

This type of option pricing, in which there’s significantly more premium to the upside call than the downside put, is extremely rare. 99% of the time, upside calls are priced cheaper than downside puts as most investors sell calls (which lowers price of calls) and buy puts (which raises price of puts) against long stock positions as hedges. The elevated price of puts versus calls is known to options traders as skew.

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Here’s a graph courtesy of Livevol depicting the pricing of Dow Chemical (DOW) options. The graph is typical for how options are priced: The out-of-the-money puts (the left side of the graph) are more expensive than the out-of-the-money calls (the right side of the graph). 

Conversely, here’s a graph courtesy of LiveVol depicting the pricing of Yahoo (YHOO) options. The out-of-the-money calls (the right side of the graph) are more expensive than downside puts (the left side of the graph): 

This extremely unusual graph shows just how much potential upside the options market is pricing in for YHOO by the end of this week.

Let’s also take a look at the at-the-money straddle for YHOO headed into Alibaba’s IPO. Right now, the options market is pricing in a move of $2.40 or 5.7 % for YHOO by Friday afternoon. If a trader wanted to buy this elevated volatility through the use of a long straddle (the purchase of the 42 call and the 42 put), he would need the stock to move at least $2.40 to break even.

If you decide to buy calls or puts in YHOO for this event, please note that the September options expire on Friday. Therefore, the options will be all or nothing propositions. If your calls or puts finish in-the-money, you may be forced to buy or sell the stock depending on your position and your relationship with your brokerage provider. Or you could simply exit your entire position before the close of trade on Friday.

Options will begin to trade on Alibaba on September 29. 

Your guide to successful options trading,

Jacob Mintz
Chief Analyst, Cabot Options Trader
Twitter: @Jacob_Mintz


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