Potential Options Payoff in Post-Covid China Rebound

The Chinese economy is starting to show signs that it is rebounding better than other economies around the world. China was the first country that had to battle the COVID-19 virus. It would make sense that they are ahead of the curve in terms of the overall cycle in recovering as well.

One company that has already seen an improvement in its earnings and revenue is NetEase (NTES). The internet content and information provider saw an increase in growth in the second quarter and the company will report third quarter results in mid-November.

NetEase has seen earnings grow by 9% per year over the last three years, but earnings grew by 28% in the second quarter. Revenue has grown at a rate of 6% per year over the last three years and it jumped by 22% in Q2.

Another thing I like about NetEase is that there is a sense of bearish sentiment toward the stock.

The short interest ratio is at 4.23 currently and that is higher than the average ratio. The ratio was at 1.04 at the end of March and the current reading was for the end of September.

That is a four-fold increase in six months and indicates that the pessimism is increasing.

Oversold territory

The company reported earnings on August 13 and the stock proceeded to move higher for another two weeks. After peaking on August 26, the stock started drifting lower for the next eight weeks.

This caused the stock to move from overbought territory to oversold territory based on the weekly stochastic indicators. It also caused the 10-week RSI to move out of overbought territory and down below the 50 level.

Looking at the history of the stochastic indicators, they haven’t been in oversold territory since August 2019. After that reading, the stock rallied 50% in the next six months.

The RSI hadn’t been below 50 since the March low and when it reversed higher off of that low, the stock nearly doubled in five months.

With a five- to six-month timeline in mind and given the 50% gain from the 2019 low and the 100% gain from the low in March, I like the idea of using options to take advantage of the current setup.

The March 2021 options expire approximately five months from now. The 80-strike calls are currently priced at $12.50 with the stock trading at $86.56. This means that the options are approximately half intrinsic value and half time premium.

If the stock rallies by 23.5% from the $85 level, it would put the stock at $105 and the options would double in value. If the stock were to gain 50% like it did from August ’19 through February ’20, it would mean the stock was trading at $127.50.

This would make the 80-strike calls worth $47.50 and that would be a 280% gain from the current price of $12.50.

With the company set to report earnings in the next three weeks, I would suggest using the in the money options because the options should be a little less volatile.

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