Alibaba (BABA ), the Chinese e-commerce company that has around 80% market share of the Chinese e-commerce market, recently raised $25 billion by listing on the NYSE in what is to date the largest IPO ever. (See article: Five Things To Know About the Alibaba IPO .) The surprising aspect of the IPO is that investors are not actually buying an ownership stake in Alibaba but are buying shares in a Cayman Islands registered holding company that has a claim on Alibaba’s profits. So the investors don’t actually own any shares of Alibaba but only have a claim on the profits. The risk these investors face is that this contract is only enforceable in a Chinese court, where the validity of the contract may be contested.

The company generates most of its revenues from three of its websites: Toabao – a C2C service similar to eBay, Tmall – a seller of branded merchandise, and Alibaba.com – a B2B service. It also owns alipay.com, a Chinese version of Paypal, and has stakes in Sina Weibo (the Chinese version of Twitter (NYSE: TWTR )) and Youku Tudou (the Chinese version of YouTube). Alibaba sold around $300 billion in gross merchandise for the year ending June 2014, which is higher than Amazon (NASDAQ: AMZN ) and eBay (NASDAQ: EBAY ) combined, though its revenues of around $9 billion are dwarfed by Amazon’s $75 billion. This huge potential for Alibaba to grow is what investors are betting on.

Though Alibaba’s main competitor is Amazon, there is a difference between the business models of the two companies. Alibaba operates using a marketplace model, i.e. it does not have any warehouses or inventory of its own but merely connects buyers with sellers, thereby having higher margins. Amazon, on the other hand, invests heavily in warehouses and logistics and operates in a manner similar to that of a normal retailer. Both Amazon and Alibaba dominate their home markets, but the main question is whether or not they will be able to replicate that success in other markets. Alibaba has gone on an acquisition spree recently by spending nearly USD 8 billion on acquiring startups. The next big opportunity that Alibaba has identified in the Chinese market is m-commerce (mobile commerce), i.e. transactions through mobile devices, the market for which is expected to cross 3 trillion yuan by 2017 and in which Alibaba holds a dominant position. (See article: M-Commerce Continues To Grow .)

There are, however, some concerns regarding Alibaba’s acquisitions after it acquired a Chinese football team and found out about accounting irregularities at one of the companies it acquired. Given the ever-changing dynamic of technology, it is very difficult to predict the next product or service that is going to succeed. The Chinese internet search engine Baidu is already experimenting with online-to-offline services that will enable customers to use the internet to make purchases from physical stores. Tencent, the owner of WeChat, the messaging service, has also entered this market. These risks posed by changing market prospects, as well as the questionability of certain Alibaba acquisitions, are also borne by the investors of Alibaba, since all of this could directly affect Alibaba’s profitability and thereby its share price. An effective tool to hedge against such risks is put options that allow you to limit your downside risk while at the same time retaining exposure to any upside movement.

Alibaba’s options are traded on various exchanges in the US. Stock options are standardized and traded on exchanges like the NASDAQ. (See article: The NYSE and Nasdaq: How They Work .) Options contracts have various expiration dates ranging from a few weeks to 2 or 3 years and multiple strike prices. (See article: Options Basics: How To Pick The Right Strike Price .) A typical option chart looks like this:

The price paid for an option depends on a lot of factors, such as the stock price, strike price, expiration date and interest rates. All these factors are determined by the market and hence pose no problem for the trader. The variable that has to be estimated to get the option price is volatility.

Given the recent listing and based on recent tech IPO’s, the volatility is likely to be on the higher side with put options priced higher than call options. In option parlance this is called a bearish skew, as a put option with similar expiry date, strike price and distance from stock price is priced higher than a similar call option due to more demand for downside protection in the form of put options.

Existing shareholders can also sell covered calls (basically selling out-of-the money (OTM) call options with Alibaba stock already owned) and collect the premium. Though this strategy does not provide full downside protection, it does cover some of the downside in the form of premiums.

Though options are well known for their use as hedging instruments, they can also be used to get exposure to an underlying stock at a fraction of the cost of buying it outright. Deep-in-the-money options would mimic the performance of the stock. For example, if you want to purchase 100 shares of Alibaba, at $110, it costs $11,000. An option contract with 100 shares underlying and a strike price of $110 would cost around $3.40 per share, or $340 in total.

If you buy a Jan. 15, 2016, 120 strike call option at $17, the strategy would be profitable above the sum of $120 and $17, which is $137. The maximum loss that you can suffer is $17, which is better than if the underlying stock had been bought directly. The delta of this position would be less than 1, which is to say, the option price would not move in proportion to the stock because it is an out-of-the-money option.

If a deep in-the-money option is bought, say the Jan. 15, 2016, 105 strike call option (no volume currently), the change in the option price would be almost in proportion to the change in the underlying stock and would give a return similar to the stock until at least 3 months before expiry of the option when the option value starts falling due to time decay.

It is also possible to invest using call spreads, where one call option is sold and another call option is bought. This would have a lower cost but both upside and downside effects would be capped.

The Bottom Line

Though options are used for hedging and trading, it is also possible to use options to gain exposure to stocks at a fraction of the cost with minimal downside risk. A deep-in-the-money call option would have a delta close to 1 and would mimic the performance of the stock. In the case of Alibaba, given the nature of the industry it is engaged in and the uncertainty involved in the long run, it probably would make some sense to have some downside protection in the long run.