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Alibaba (BABA) has been outperforming the market for the past few months and is showing improving relative strength.
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BABA stock is above the 50-day moving average, and that key line is beginning to turn upward.
One neutral to slightly bullish way to play the stock could be via a bull put spread.
As a reminder, a bull put spread is a defined-risk strategy, so you always know the worst-case scenario in advance.
This type of trade will profit if BABA stock trades sideways or higher and sometimes even if it trades slightly lower.
With Alibaba closing around 117 Friday, if we use the July expiration, we can sell a 105 put and buy a 100 put for around $1.00.
Trade Generates $100 In Premium
Selling this spread would generate roughly $100 in premium with a maximum risk of $400.
If the spread expires worthless, that would be a 25% return in around three weeks, provided BABA stock is above 105 at expiration.
The maximum loss would occur if Alibaba closes below 100 on July 15. That would see the premium seller lose $400 on the trade.
The break-even point for the trade is 104, which is calculated as 105 less the $1.00 option premium.
In this market environment, I would set a pretty tight stop loss and look to close the trade if BABA stock drops below 110.
Limiting Losses On Option Trade
Otherwise, another good rule of thumb is to limit the loss to two times the premium received, which in this case would be $200. Sticking to this stop loss level will help avoid large losses if the trade goes south.
According to the IBD Stock Checkup, BABA stock is ranked No. 4 in its group, and has a Composite Rating of 66, an EPS Rating of 72 and a Relative Strength Rating of 60.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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