To be 100% frank, if a trading analysis – especially one focused on options – doesn’t mention the concept of basic versus conditional probabilities, it lacks utility to the point of being worthless. Yes, that’s a strong statement, but the financial reporting industry’s highest standards desperately need to be raised.
If we’re being intellectually honest, I’m not sure what the rebuttal would be.
Today’s options-focused report will focus on Nike (NKE). Currently, the Barchart Technical Sentiment Indicator rates NKE stock at 56%, with an identified risk that the near-term situation could continue to be negative. So if I want to be bullish on NKE stock, don’t you think I need a quantified reason for my optimism?
Let’s look at the sport of baseball. Many of you watched the captivating World Series between the Los Angeles Dodgers and the Toronto Blue Jays. In most games, each team’s manager had to make critical personnel decisions. If he replaces an arm or bat, that player cannot return later in the same game.
As such, managers must make Bayesian inferences, determining whether the potential reward of the replaced player exceeds the opportunity cost of maintaining the roster as is. This is where you need to know basic probability (staying put) and conditional probability (making a change).
It is totally irrational for a manager not to know these probabilities; this would be considered professional misconduct. And yet, in finance, millions of retail traders trade options based on some rando’s opinion of intrinsic value or breakout patterns.
To be frank, analyzing the options market is not a substitute for calculating probabilities. While NKE stock was one of 500 names on Barchart’s Unusual Stock Options Volume list on Friday — and while the options flow shows clear trading sentiment at $292,000 — it’s difficult to extract any meaning from it here.
Ultimately, this is a derivative market – and individual calls and puts can be traded for a variety of reasons.
At a minimum, every trading-centric analysis should contain empirical probability, also known as relative frequency. This is the number of times a specific event has occurred divided by the total number of observations. Additionally, a truly detailed analysis will include a price or density clustering statistic; that is, the result that occurs most frequently.
Looking at NKE stock using data since January 2019, the 10-week forward results form a distribution curve, with prices ranging from approximately $63.50 to $65.25 (assuming an anchor point of $64.59, Friday’s close). Under baseline conditions, price clustering is expected to occur at this level, a consequence of the week-to-week overshoot rate ranging from approximately 46% to 52%.
However, the argument here is that the stock of NKE is not in a baseline or homeostatic state. Instead, security is organized in a 3-7-D formation: three weeks up, seven weeks down, with an overall downward slope. In this sequence, NKE’s risk tail stays roughly the same, but the reward tail climbs up to $67.50. Better yet, the excess rate varies from 51% to almost 60%.
Furthermore, price clustering is expected to be predominant at $64.80. This means that there is a positive delta of almost half a percent that is not taken into account by market makers. Combined with the higher reward tail, the collective picture represents informational arbitrage.
In fairness, the above methodology is not common, which is why it may initially cause skepticism. However, the basis of this quantitative model arises from observations made by GARCH (Generalized Autoregressive Conditional Heteroskedasticity) studies, which describe the diffusional properties of volatility as clustered, non-linear phenomena.
Simply put, different market stimuli lead to different market behaviors. Currently, NKE stock is not structured in a normal but rather distributive state. However, red ink historically attracts bullish activity. Although there is no guarantee that the rise will begin, there is a better chance of it happening based on actual empirical data.
With the above market information, two interesting ideas can be considered. First, the most conservative approach is the 63/66 bull call spread expiring on November 28. This trade involves purchasing the $63 call and simultaneously selling the $66 call, for a net debit paid of $164 (the maximum that could be lost in the trade).
If NKE stock rises during the second leg ($66) at expiration, the maximum profit is $136, a gain of almost 83%. Here, the break-even point stands at $64.64, which is a realistic target given the price density dynamics associated with the 3-7-D sequence.
Those looking to step up their aggression can consider the 63/67 bull spread, which also expires on November 28. This transaction requires a net debit of $201, with a maximum profit of $199, which translates to a 99% payout. In this case, the break-even point is $65.01, which is a bit exaggerated but still reasonable.
For both trades, some luck will be required to trigger the maximum strike price. However, because investors tend to buy the dips – especially in 3-7-D conditions – the odds may be more favorable than you think.
As of the date of publication, Josh Enomoto did not have (directly or indirectly) any position in any of the securities mentioned in this article. All information and data contained in this article are for informational purposes only. This article was originally published on Barchart.com
