$TENCENT(00700)$ and $NetEase(NTES)$ both experienced a significant decline on Friday, which would have been an opportunity for me in the past. However, given the current overall negative sentiment surrounding Chinese concept stocks, I'm not very inclined to take action without first assessing the severity of the situation.
If it were something on the level of NetEase splitting from $Activision Blizzard(ATVI)$ or Tencent imposing restrictions on minors' gaming time, then it wouldn't be a big deal and I would consider buying. But this time:
The document will fundamentally affect the company's revenue. Under constant bandwidth and channel costs, the high-profit game business will have a leveraged impact on the overall margin. If this is really implemented, it will visibly affect the valuation. My model indicates that the impact on Tencent's margin may be in the mid-single digit percentage, while the impact on NetEase's profit margin may as least mid-teens.
Especially for NetEase, the inducement is fully delighted to what it operates. Netease heavily relies on channels and major clients. Every clause is right on target. I even suspect that the author of the official document is a former gaming addict "harmed" by NetEase games (later transformed and landed a government job).
For Tencent, it should immediately increase the buyback to 1 billion HKD (usually a maximum of 400 million) to stuggled the support of 275. If there is no buyback, combined with the selling pressure from $Naspers Ltd.(NPSNY)$, a falling below 260 is not out of the question.
So, what are long investors are betting on?
1. An oversold rebound. This is purely an emotional bottom-fishing move. Whether you use technical analysis or quantitative indicators, this kind of bottom-fishing is often very short-term with a relatively small target space. For example, buying Tencent at 265 and selling at 280, but usually not aiming to return to the pre-news level of 310.
2. Document will not actually be implemented. This is somewhat like betting on a high-yield probability event like a failed acquisition case. Although it's a draft, there is no precedent for it not being approved. Based on the lack of communication with major companies this time, there is a certain probability of subsequent detailed modifications (a bit higher, but still a small probability event), but the general direction will still be industry norms. This is a true reversal bottom-fishing move, and the target price may need to at least recover to the pre-news level.
3. A rebound with extremely low valuation. The sentiment in the Hong Kong stock market is very low, and the valuation of Chinese assets has been compressed, so the magnitude of valuation adjustment may be significant. However, there are fewer and fewer investors looking for bottom-fishing value opportunities.
So, what investment strategy offers better cost-effectiveness?
Options trading will have better cost-effectiveness than simple stock trading because it requires lower capital and these risk event gambles should not dominate the asset portfolio.
1. Single Leg
If you are purely looking for a short-term oversold rebound on the bullish side, then buying a Call option, especially an Out-of-The-Money (OTM) Call, is more suitable. If the rebound does not materialize and sentiment worsens, Tencent falling below 240 and NetEase falling below 80 could happen quickly. The loss from OTM options would not be too significant.
If you choose a more conservative approach by selling PUT options, then you must manage your position based on the cash you can secure. The choice of strike price must be one that you are willing to take the underlying stock and hold it for the long term. If sentiment deteriorates in the short term, Tencent at 240 or even 220, and NetEase at 80 or even 70 are not out of the question. It purely depends on your risk preference.
Also, since the consultation draft will be completed on January 21st, it is not certain that this event will continue to ferment before mid-January. Selling PUT options with expiration before mid-January can be considered. Personally, I would choose Tencent options with a strike price around 230 expiring in one month, and NetEase options with a strike price of 75.
2. Option Strategies
I do not highly recommend Covered Calls because they may not offer good risk-reward ratio, unless there is a strong short-term oversold rebound that exceeds your target price.
Among the spread strategies, I recommend Bull Call spreads, which involve buying low-priced Calls and selling high-priced Calls, especially if you believe in an oversold rebound rather than a reversal. I do not recommend Bear Put spreads because the sharp decline may not continue in the short term, resulting in overpaying for low-priced PUT options. Also, if sentiment is optimistic, it's better to trade Calls instead of PUTs.
Of course, my favorite strategy is the Risk Reversal , especially when you are already bullish on bottom-fishing.
This combination involves a Long Call and a Short Put. The advantage is a very low margin requirement and it can replicate the movement of the underlying stock. If the strike price is at 90, the profit/loss (P/L) looks like this:
Of course, you can also choose different strike prices. For example, if you Buy a 90 Call and Sell an 85 Put, you have some safety cushion with a slight outlay of premium, and there is no restriction on the upside potential.
Happy Trading!
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