Alphabet (NASDAQ: GOOG) isn’t exactly carrying a whole lot of weight for the broader technology space. On a year-to-date basis, the ticker has gained a little over 9%, which is quite modest for its standards. Moreover, GOOG stock is down 2.37% in the trailing month ending Aug. 12. There doesn’t seem to be much excitement for the name, which from a contrarian’s perspective makes the idea intriguing.
No, I don’t think it’s a wise idea just to randomly acquire securities merely because they’re on a downtrend. Of course, Warren Buffett has taught us that we should look to be greedy when others are fearful but there’s the thing: we have to be strategic in our contrarianism. Here, I believe GOOG stock presents a fundamentally sound argument.
Look, Alphabet isn’t exactly trouble-free. Plus, in the age of artificial intelligence, other players have arguably made bigger strides. Combine corporate concerns with the overall economy and you have reason to be cautious with Alphabet stock. Nevertheless, the underlying company is the undisputed stalwart in search and commands a litany of attractive and viable brands.
So, whenever GOOG stock encounters a period of prolonged weakness, my estimation is that this negative circumstance won’t last long. Google is probably a permanently relevant brand and I’m going to (reasonably) assume that institutional players will bid up any discounted opportunities.
Specifically, I anticipate a conspicuous swing in Alphabet stock over the next three weeks. If so, the 350/355 bull call spread expiring Sep. 4 may be a tempting idea. To be sure, it’s risky because of the near-term expiration date. However, at a net debit of $210 — with the opportunity to make a maximum profit of $290 should GOOG rise through the $355 strike at expiration — the overall cost isn’t too onerous.
That said, there are huge probabilistic risks with the above call spread that should be acknowledged.
Black-Scholes Doesn’t Have Great Things to Say About GOOG Stock
At time of writing, Alphabet stock trades at $342.37. Given the full profitability target of $355, you’re looking at about a 3.7% move higher over the next three weeks. It’s quite aggressive as the implied volatility (IV) for the Sep. 4 options chain is only 28.28%. Historically, the IV would usually land at this time around 43%.
Right now, the options market is signaling unusually low forward mobility for GOOG stock. When applying the Black-Scholes formula, the anticipated probability of the ticker reaching $355 at expiration is only 29.67%. That’s super low and much of it stems from the historically low IV.
Making matters worse, the probability of the 350/355 call spread breaking even at expiration is only 34.7%. No matter how you cut it, this trade — under the presupposed framework of Black-Scholes — is doomed to suffer a negative expected value (EV) over the theoretical long run.
Still, we shouldn’t just give up on the trade idea before we’ve fully assessed the risk. Because the equities market has not been proven to be determinative, no one can tell you what Alphabet stock is precisely worth in the future. By logical deduction, when experts do assign probabilistic estimates, those numbers are based on presuppositions.
What is a presupposition? If you ever get cornered by a street evangelist who tells you that there’s only one way to ultimate truth, that’s a presupposition. By necessity, no one knows what will happen in the great beyond. So, as convincing as religious experts may be, they’re reasoning under uncertainty.
And that’s what Black-Scholes — just another reasoning mechanism under uncertainty. In this case, the framework offers an implied probability of GOOG stock reaching the $355 target at expiration through a presupposed random walk.
In other words, under random conditions and given the initial volatility expectations, we’d expect Alphabet stock to hit $355 on Sep. 4 around 30 times out of 100. It will break even around 35 times out of 100, which are obviously not great odds.
The thing is, you don’t have to accept these numbers as gospel truth.
Order Flow Imbalance Potentially Signals Upside for Alphabet Stock
Primarily, the reason why you shouldn’t take Black-Scholes-derived probabilistic estimates at face value is the random walk itself. As other experts have demonstrated, the market is reflexive. It doesn’t operate in a vacuum but responds to various catalysts and influencing agents.
Subsequently, I believe that order flow imbalances represent a major influencing factor. For example, if GOOG stock suffers a prolonged downward trend, that is likely to trigger buy-the-dip sentiments from institutional players. And that’s why I anticipate a near-term pop in the coming weeks.
Specifically, in the last 10 weeks, Alphabet stock has only managed to print three up weeks, leading to a downward slope. Under this 3-7-D quantitative sequence, the ticker tends to rise above the random baseline for the next three to four weeks, followed by a period of underperformance relative to the baseline. That’s why I’m interested in near-expiry call options.
Under 3-7-D conditions, which has only flashed 11 times on a rolling basis since January 2019, Alphabet stock has hit the equivalent of the $355 strike price a total of six times at the end of week 3 (Sep. 4). Of course, the extremely small sample size forces us to view these observed stats with a massive grain of salt. Nevertheless, on the surface, the success ratio is 54.5%.
What’s interesting is that, largely as a consequence of the small sample size, the probability of hitting breakeven under my model is also 54.5%. Basically, when the aforementioned signal flashes in the charts, we tend to see an exuberant move higher.
Now, I’m going to keep a relatively conservative view on GOOG stock, ignoring the really high payout trades because of the low IV. For me, the $355 strike represents a balanced perspective.
Expected Value Calculations Are the Cherries on Top
If you assumed that Black-Scholes is telling the ultimate truth, the EV calculations would be wildly bad. For the 350/355 bull spread, you would be expected to win $86.04 (29.67% x $290) and lose $147.69 (70.33% x $210). That’s an outrageous net loss of $61.65, assuming you bet on this exact trade multiple times over the long run.
However, the calculus shifts dramatically under my nonrandom inductive model. Under this framework, you would be expected to win $158.05 and lose $95.55. That comes out to an expected net gain of $62.50, which is basically the inverse of the Black-Scholes model.
Because our approaches are producing completely different expectations, you’ll want to sit down and research GOOG stock. Still, if you do give credence to inductive reasoning, there may be a compelling opportunity here.
