$JD Power?

by Dan June 20, 2016 2:57 pm • Commentary• Trade Ideas

On June 14th, I expressed a near term bearish view in Alibaba (BABA) with a defined risk trade that looked to finance August near the money puts with shorted dated puts of the same strike (Accounting for $BABA’s Bounce), here was part of the rationale:

From where I sit, the confluence of events over the last month might be as good as it gets. Two pieces of bad news met with two pieces of good news, an SEC investigation and Softbank share sale off-set by the company’s willingness to buy back shares and their bump to revenue guidance. The next piece of news that is not earnings news may be unwanted progress by the SEC, or a short term blip to earnings when the company reports their fiscal Q1 in the first half of August.

At the time I considered a pairs trade, with a long biased trade in Chinese online retailer was making new all time lows.

JD 2 year chart from Bloomberg
JD 2 year chart from Bloomberg

Which was in large part why I did not seriously consider as its generally a bad rule when pairs trading to short the strong stock and buy the weak one, without a catalyst for either.
Well today’s announcement that JD and Walmart (WMT) are forming a strategic alliance is a catalyst. From the press release:

The agreement between the companies includes a wide range of businessvinitiatives, covering both online and offline retail. For Walmart, the alliance greatly expands its opportunity in China e-commerce and provides its stores and Sam’s Clubs with potential traffic from JD.com’s significant base of online customers and vast same-day delivery network to serve its customers. JD.com will leverage Yihaodian’s strong brand and business in eastern and southern China and in key product categories such as high-quality grocery and household goods, both of which complement its own geographical and product strengths. In addition, JD.com’s customers will gain access to a wide range of new and imported items from Walmart and Sam’s Club.

As part of the deal, WMT will gain an approximate 5% stake in JD.

This deal highlights just how difficult it is for foreign enterprises like WMT to do business in China. Back in 2011 WMT took a minority stake in Yihaodian, an e-commerce site in China geared towards upper middle class female shoppers, and then in 2015 took full control.  The announcement of today’s sale of Yihaodian to JD suggests that WMT execs would rather partner with an established e-commerce player in China rather than build up a niche player.

There is no financial info disclosed, so it’s hard to guess what this means for either company. WMT’s stock has sold off  a bit intra day since the announcement, while JD is up about 6%, about where it was when the announcement became official (it was higher already on the rumor). Investors seem to like the benefits for JD more than WMT so far.

With BABA it made sense to sell short dated options to finance owning longer dated ones targeting their next earnings events. Looking in the other direction with JD still near its lows but bouncing today, I prefer defining my risk and targeting a decent upside while knowing what I can lose if this is just a headfake higher.

JD’s next earnings event should fall in August expiration and may offer some more insight into the financial benefits of the WMT deal. I’ll define my risk and not have much extrinsic premium doing so through an in-the-money call fly.

So What’s the Trade?

*JD ($21.30) Buy the August 20/25/30 call fly for 1.65
  • Buy 1 Aug 20 call for 2.60
  • Sell 2 Aug 25 calls at .50 (1.00 total)
  • Buy 1 Aug 30 call for .05

Rationale – This trade break-even at 21.65 on the upside. Therefore it has very little extrinsic premium as the break-even is just above where the stock currently resides. On the downside the most that can be lost is 1.65, so you’re stopped out if the stock were to drop below $20. The trade offers max gains of up to 3.35 at 25 in the stock. We like this trade in particular paired with our BABA short delta trade because of the possibility on winning with both but also the defined risk if both were to go in the same direction as gains from the winner could easily outpace losses from the loser if they both move in the same direction with the broader Chinese market.