5 Ways to Trade the Alibaba IPO
On Friday shares of the Chinese e-commerce conglomerate Alibaba will begin public trading, in what promises to be the biggest IPO in US history. Shares in Alibaba (BABA) are expected to raise more than $24 billion, amounting to more than half the proceeds of all other offerings this year, and this is the event that everyone on Wall Street’s talking about.
So, is the Alibaba IPO really worth your attention? And if so, how do you plan to trade it?
In this article we’ll take a look at a few simple strategies that you could use to profit from the BABA listing over the coming weeks, whether you’re a daytrader looking for a quick scalp or a buy-and-hold investor looking to purchase deep value.
Why Trade an IPO Stock?
IPO’s can be great to trade for one simple reason – there is limited historical information available about how the company is valued in the open market – this can really help to level the playing field because everyone is somewhat “in the dark”, institutions and hedge funds included.
On the other hand there are also certain pieces of information relating to IPOs that are known, and trading ideas can be built around reactions to these scheduled events.
The trading environment following an IPO is often volatile, meaning that there can be significant price swings from which to profit; as always this is a double-edged sword and you should exercise caution and control your risk – don’t get caught up in all the hype, make sure you stick to your trading plan, and don’t over-leverage.
TRADING IDEA #1 – A Pairs Trade
Pairs trading simply involves finding two stocks that usually move in tandem (normally because they belong to the same sector and are subject to the same fundamental influences on their price), and then waiting for a brief discrepancy in their price. When one stock has become overbought relative to the other, the overbought stock is shorted, and the oversold stock is bought. The idea is that the price of both stocks will eventually converge as they trade back in line with one another. As you’re both long and short, pairs trading (often known as “statistical arbitrage”) also provides effective insurance against significant swings in the broader market.
You can’t really use the Alibaba (BABA) stock for a statistical arbitrage – it hasn’t yet traded so you can’t tell whether it is overbought or oversold because it has no historical price. But don’t abandon hope yet . . .
Two other companies are publicly known to have very large shareholdings in Alibaba. These are Softbank (SFTBY) and Yahoo (YHOO), with shares of 37% and 24% respectively. This information makes for a great Statistical Arbitrage opportunity – with such large shareholdings, the price of each of these two companies cannot diverge too significantly from that of Alibaba – their BABA shareholding is the fundamental factor that ties them together.
To trade this idea following the IPO you just need to wait for one stock to overshoot BABA while the other underperforms. The first stock can be shorted, and the laggard bought. This is the same as a widening of the spread between the two stocks, (the spread can be calculated by dividing one by the other).
You’ll need to purchase the two stocks in proportions using the following simple formula, which provides parity for their individual share prices weighted by their exposure to Alibaba as a percentage of their market cap.
Allocation to YHOO = ( ( SFTBF Price * 0.61 ) / ( YHOO Price * 0.83 ) )
For example, if YHOO is trading at 44 and SFTBY at 76 then for every share of SFTBY that you trade, you will need to trade ( (76*0.61) / (44*0.83) ) = 1.27 shares of YHOO.*
* This formula provides simple price parity with exposure weighting; for beta-neutrality read this article.
TRADING IDEA #2 – Join the Underwriters
The first day of an IPO is a huge media-driven event with everyone watching the price of the company’s stock like a hawk. Despite the marketing hype, not all IPOs get off to a flying start, and when they begin to trade below their initial offering price they are referred to as a “broken deal”.
The IPO of a large company is always underwritten by a major brokerage house or investment bank. The underwriter is permitted under federal regulations to make stabilizing bids to support the share price at the offering price, and underwriting institutions have enormous firepower with which to do so.
This can provide a great short term opportunity for those daytrading an IPO at its debut. Look for massive volume trading at the bid as price falls, and then join the bid with a limit order just above the offering price. High volume at the bid means that a large number of participants are dumping their shares using market orders, and the underwriter is supporting the market by sitting on the bid and absorbing these sell orders.
A fantastic example can be found in the first day’s trading for Facebook (FB) in 2012. High volume at the bid can be seen on the chart below (the blue bars on the histogram), culminating with over 12 million sell orders absorbed at the bid by the underwriter in just a few minutes, all within a few ticks of the initial offer price of $38. The price is not permitted to fall below this level and begins to rally.
A note of caution – this strategy is only good for a quick intraday scalp – the day following the IPO the underwriters stepped aside and Facebook shares went into free-fall for the next three months.
TRADING IDEA #3 – Buy Losers After the Lockup
All IPOs are subject to something known as the “Lockup Period”. This is a legally binding contract between the underwriters and the insiders prohibiting the sale of shares, for a period of between 90 days (the minimum provided for by the SEC Rule 144) and 24 months. If a stock does not fare well on the open market following its IPO, the senior officers and major shareholders of the company will be unable to liquidate their own shares until the lockup period expires.
Although it might seem counter-intuitive, this information can be used to find some great long entries with guaranteed liquidity. Look for issues that have already sold off heavily and then begin to rally immediately that the lockup expires. Quite often these shares are trading at or below NAV and represent deep value; most of the selling has often been exhausted by this stage. The chart below shows Chegg Inc (CHGG), an online textbook rental company that fell hard from its offering price of $12.50. The lockup expired on 12th May 2014, and this day marked an all-time low for the stock, after which it began to rally.
TRADING IDEA #4 – Exploit Other Trader’s Mistakes
When a new stock begins trading there is no historical price information available for it. No price chart, no trend lines, no average price, and no highs and lows. This means that technical traders are often forced to sit on the sidelines with no opportunity to enter the market. Some are more patient than others.
When the IPO stock makes its very first short term high or low, look for a high volume of participants entering in anticipation of a full reversal; if they’re wrong then their stops will get run, and this can provide a great long/short entry around the stock’s historical high/low. If you need to short the stock and shares are not available, consider using a derivative such as CFDs.
TRADING IDEA #5 – Hedge Purchases and Loan to Short Sellers
This final suggestion is a bit more complicated and you’ll need to have a decent account size for it to generate worthwhile profits. Although it’s also pretty much risk-free . . .
Following an IPO, the majority of shares are held by the underwriters, who are prevented by SEC rules from loaning shares directly for short sale. This means that the number of shares available for shorting is limited to those held by institutional and retail investors.
An interesting opportunity for the Alibaba IPO exists if you reside in a country where you can access over-the-counter derivative products such as CFDs or Financial Spreadbets on the IPO company. AvaTrade are currently offering the ability to trade long or short on Alibaba using such products (and are also offering a fantastic deposit bonus of up to $10,000 for new accounts), and would be an ideal choice for this as they operate internationally.
Once the initial volatility has subsided on the first day of the IPO, shares can be purchased in an account with a firm such as Interactive Brokers who operate a stock-lending program, and an equivalent value sold short with a derivative firm such as AvaTrade (by using leverage to do this you won’t need to put the full amount down). You’re now completely hedged against price changes in BABA stock, but stand to collect a risk free return by loaning the stock you own for short sale. Just remember to liquidate both positions simultaneously and within 30 days, and that you will also incur carrying costs for the derivative position.
CONCLUSION
IPOs are “once in a lifetime” events for a stock and can present well-prepared traders with tremendous opportunities for profit, but also significant risks.
If you’re considering trading Alibaba stock following its IPO this week we hope that the information above will have armed you with some useful strategies and that you can find a way to profit amidst all the hype – however the market reacts!
