By Dmitry Pargamanik
This Bull Call Spread Could Profit 88% on a Stock Rally in BABA
- Call spread targets $101 in BABA Stock
- Bull spread is theoretically 9% undervalued
See More Trade Ideas for BABA
What is attractive about this BABA call spread?
This BABA trade card helps you identify a bullish opportunity with a statistical edge.
The bull call spread image at the top shows a theoretical value of a trade at $1.77, which is $0.17 lower than its market price. The theoretical value of $1.77 was computed using historical data. The market price of $1.60, on the other hand, is the pricing of the trade based on the current market.
However, the most important information displayed by the trade card is the theoretical edge, estimated at 10.4%. It represents the anticipated long-term average return on each trade (assuming the BABA future price return distributions will be the same as in the past).
To help you better understand this, let's go over how the theoretical value was found.
The following infograph for BABA displays how the the theoretical value was determined.
NOTE: The probabilites were caculated using actual historical data.
Let's walk through this trade idea
We want to determine if this trade opportunity is a good deal and why.
The first thing we want to do is list out all the information that is important to evaluate the trade. We will split the information into knowns and unknowns.
What we know
Strategy: BABA Debit Call Spread
|Buy:||21-Apr-23 98 CALL|
|Sell:||21-Apr-23 101 CALL|
|Market Price [Debit]:||$1.60|
|Trading Days Left to Expiration:||17|
Now let's figure out the potential value of this spread at the end of 17 trading days (when these option contracts expire). The value will depend on the stock price on Apr 21, 2023 (i.e. on the expiration date, 17 trading days as of the time of this writing).
[Drops more than -2.4%]
Between $98 and $101
[Stays Between -2.4% and +0.6%]
[Goes up more than +0.6%]
|Value of Spread:||$0.00||$0.00 to $3.00||$3.00|
What are the outcomes for this BABA bull call spread?
Scenario 1: If the stock falls below $98.00 (i.e. drops more than -2.4% from the current price of $100.38), then both calls will expire worthless and this spread will be worth $0 at expiration.
Scenario 2: If the stock is anywhere between $98 and $101 (i.e. stays between -2.4% and +0.6%) at expiration, then the spread will be worth $0.00 to $3.00 (depending on the price of the stock at expiration). Note: By clicking the Report tab on a live trade card, you can see the various outcomes for the spread value within the Payout Diagram section.
Scenario 3: If the stock is above $101 (i.e. increases by more than +0.6%), then the spread will be worth $3.00.
What we don't know
The problem is that we don't know where BABA stock price will be at expiration (uncertainty). If we did know, then the value of this spread would be easy to calculate.
Therefore, the next best thing we can do is use historical data to estimate the probabilities of the 3 scenarios above (similar to how an insurance company calculates the probability of accident claims).
How to estimate the call spread value
Using historical data, let's find out the following to see how the stock tended to perform over a 17 day trading period.
How frequently did BABA
- Drop by more than -2.4% (Scenario 1)
- Stay between -2.4% and +0.6% (Scenario 2)
- Go above +0.6% (Scenario 3)
Fortunately, we have the benefit of computers to do the tedious work for us. We will use 4 years of data and adjust for earnings dates and implied volatility events.
Here are the results:
Study: Theoretical Value of Spread Using Historical Stock Return Distributions
4 Years of Data, 16 Day Hold Intervals
Exclude Earnings Periods, 22 Total Observations
|Stock Returns||At or Below -2.4%||Between -2.4%
|# Occurrences [%]||9 [41%]||1 [5%]||12 [55%]|
|Avg. Theo Spread Value
for Stock Return
(Click on the Report tab on the top right of a live trade card to see this data in the Theoretical Value Analysis section.)
The historical data shows that, over a 17 day period, BABA dropped more than -2.4% (Scenario 1) in 41% of the observations. Also, 5% of the time, BABA price closed between -2.4% and +0.6% for an average value of $2.85. And finally, BABA increased by +0.6% (or more), 55% of the time. Therefore, to calculate an estimated value we perform the following: (41% X $0.00) + (5% X $2.85) + (55% X $3.00). Which comes out to $1.77.
In other words, if we applied the spread characteristics (same number of days to expiration, strikes with the same distance from stock price) historically, the average end value for this bull call spread at expiration would be $1.77.
The BABA bull call spread is a great way to play a bullish outlook on the underlying stock, with limited risk. Based on BABA historical stock behavior, the strategy has a 10.4% theoretical edge.
Don't Let an Opportunity Pass You By!
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NOTE: Stock and option trading involves risk that may not be suitable for all investors. Examples contained within this report are simulated and may have limitations. Average returns and occurrences are calculated from snapshots of market mid-point prices and were not actually executed, so they do not reflect actual trades, fees, or execution costs. This report is for informational purposes only, and is not intended to be a recommendation to buy or sell any security. Neither Market Chameleon nor any other party makes warranties regarding results from its usage. Past performance does not guarantee future results. Please consult a financial advisor before executing any trades. You can read more about option risks and characteristics at theocc.com.
The information is provided for informational purposes only and should not be construed as investment advice. All stock price information is provided and transmitted as received from independent third-party data sources. The Information should only be used as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments and trading strategies. The Company does not guarantee the accuracy, completeness or timeliness of the Information.