If you’re looking for a quick, aggressive scalp, something that provides a play on current momentum, you may consider AI infrastructure specialist Vertiv Holdings (NYSE: VRT). Primarily, the premise is straightforward contrarianism. Over the trailing month, VRT stock has suffered heavy losses, down 16.25%. However, it’s an extremely relevant company, especially because of the push toward machine intelligence. As such, there’s a plausible recovery angle here.
In fact, it’s so plausible that the recovery has already begun. On the Monday session, Vertiv stock swung up by $17.65 or a jump of 9.65% over the Friday session. That’s both good news and bad news. Sure, VRT is clearly in the midst of robust momentum — and potentially, strength may beget strength. At the same time, there’s that fear of holding the bag.
Translation? VRT stock is incredibly speculative. Further, when the market appears predictable, Murphy’s law suggests that you’re about to find out the hard way that Wall Street plays by no rules but its own. Still, this is where the beauty of options trading comes into play.
We don’t necessarily need Vertiv stock to catalyze another wholesale rally. With the underlying leverage, a relatively small move (in the right direction) can generate massive payouts. Moreover, there’s compelling evidence that one particular trade — the 215/220 bull call spread expiring Nov. 20 — could be underpriced.
To be fair, the above spread looks like any other multi-leg options strategy. You just have to be willing to read between the lines to see the potential opportunity.
Why Consider the VRT Stock Bull Spread in the First Place?
The first order of business is addressing the elephant in the room. At the time of writing, Vertiv stock trades hands at $200.47. That’s going to be our reference point. For the November monthly bull spread to be fully profitable, VRT must trigger the $220 strike price on expiration. However, that target is currently 9.74% above our position.
You can see the immediate challenge. VRT stock has already gained almost 10% on Monday. What are the chances, then, that it can net another 10% without incurring some heavy drawdowns prior to expiration? If you thought that the odds are slim, you’d be right.
Obviously, no one knows what the future will bring. What we do know are the basics: the current spot price, the distance to the target price, and the days to expiration (which is about a week-and-a-half from now). We also know the current implied volatility (IV) stands at 76.83%.
These stats tell us the qualifying information to make the bull spread profitable. Whether it will be profitable is another question, as we don’t know the probability of which direction VRT stock will take. In order to make an educated guess, we must work with an initial assumption or model.
As a gold standard, Wall Street assumes that the target security will undergo a random walk between now and the expiration date. Further, the IV metaphorically represents the speed of the walking steps. Essentially, this random-walk calculation forms the backbone of Black-Scholes-based options pricing models.
Under this assumption, we may calculate that the odds of Vertiv stock randomly terminating at $75 on the Nov. 20 expiration date sit at 23.47%. So, if you were thinking that it’s unlikely for VRT to rise 10% to hit the necessary strike within the allotted time, you’d be right.
Now, if you were to straight up buy a naked call option (as opposed to a bull call spread), your actual target would be the $220 strike plus the entire premium paid for the naked call. However, with a bull spread, you’re simultaneously selling a call, thus reducing the cash outlay required.
Such a transactional structure helps mitigate the necessary percentage gain to make your trade profitable.
Addressing the Rationality Behind the Speculation
While a bull spread may be the preferred choice for attacking the $220 target of VRT stock, understanding the transaction doesn’t help us justify the trade itself. In other words, how do we know that Vertiv will actually move in the direction we want?
Again, it must be reiterated that no one knows the future. What we just calculated is that Vertiv stock only has a 23.47% chance of being fully profitable, but that might not be the full story. This ratio is what I would call the “journalistic probability” — it’s the consensus assuming that VRT stock will trade under the random walk assumption.
The key word here is “assumption.” There’s no law of nature that forces VRT stock to trade randomly. Indeed, our observation of historical data suggests that under certain circumstances, VRT typically undergoes a nonrandom walk.
Specifically, we can run algorithms to uncover an underappreciated fact. When the balance of weekly candlesticks becomes biased heavily toward the downside over a rolling 10-week period, the subsequent 10-week period tends to feature a recovery play. With VRT stock, we have witnessed the printing of only three down weeks over the past 10 weeks.
Source: Optioncharts.io
While it’s not a guaranteed inference, this nonrandom transition from a deeply bearish state to a potentially bullish state implies a probabilistic range between 35% and 45% that VRT stock may trigger the $220 strike over the next two weeks.If we assume that the actual probability will land at 42%, the expected value (EV) calculation of the November monthly bull spread — which requires a net debit of $190 for the chance to generate a maximum payout of over 163% — would come out to $20. This translates to a return on capital (ROC) of +10.53%.
Taking Advantage of the Mispricing of Vertiv Stock
In all fairness, an ROC of 10.53% may not be the most compelling idea to consider. However, bull spreads are basically offered by the market because the credit sellers believe it’s a relatively easy way to collect income. Stated differently, you should assume that, as a debit buyer, you’re walking into a disadvantageous deal.
But the difference with the 215/220 bull call spread expiring Nov. 20 is that I believe the debit buyer may have the advantage. Under a nonrandom-walk assumption and given the basic stats mentioned earlier, the EV for the trade is theoretically positive in your favor.
Of course, this all assumes that the non-random walk is the most appropriate/accurate model for VRT stock. If it is, this speculative trade deserves a closer look.
