For those seeking an unconventional — and thus highly risky — options trade, Applied Materials (NASDAQ: AMAT) may be a name to consider. While the year-to-date performance of AMAT stock is strong, up 93%, it has struggled in recent sessions. In the trailing month, the ticker lost roughly 6% of market value. Yet the extended drag could lead to a potential mean reversion.
How can I tell? Obviously, no one knows what the future will entail. But we do know that Applied Materials stock is relevant to the current tech ecosystem. Primarily, the company supplies equipment, services and software for the manufacture of semiconductor chips for electronics, flat panel displays for computers, smartphones, televisions and solar products, according to Google Finance. Better yet, artificial intelligence plays a major role in AMAT’s forward trajectory.
Rather than designing advanced chips, Applied Materials supplies the materials engineering and manufacturing equipment needed to produce AI chips. In other words, Applied is a picks-and-shovels play for the machine intelligence boom. Practically speaking, the runway should be indefinitely long for AMAT stock.
If so, any extended weakness in the name should entice professional players to view the ticker as a discounted opportunity. Quantitatively, we should note that in the last 10 weeks, AMAT stock has only printed three positive weekly candlesticks.
How many times has that happened? Since January 2019, the quant sequence has only flashed a total of 10 times on a rolling basis. By itself, this structure only represents a factoid. But it’s what happens when this signal does flash that’s most intriguing.
Based on past empirical data, the median expectation at the end of the fourth week since the materialization of the signal is a swing up of approximately 11.3%. If so, the 530/550 bull call spread expiring Sep. 18 looks intriguing.
Analyzing the Assumptions Undergirding AMAT Stock
What can be absolutely said about the future of Applied Materials stock or any other public security? From an epistemological point of view, absolutely nothing. We can’t even say that the future will occur sequentially because even the concepts of “before” and “after” are presuppositional.
I’m sorry but the very concept that just because we observe time in a linear sequence does not mean with absolute certainty that time operates in that manner. That’s why I don’t like these “creation-requires-a-creator” theological arguments. Who says that the universe is a creation? It could be but empirically, we’re dealing with yet another presupposition.
What’s my point? If we’re making arguments about the unknown future, they’re necessarily presuppositional. And that’s important to realize because this means that you shouldn’t automatically privilege Wall Street-derived probabilities as the gold standard — frankly, they could be wrong.
For example, the breakeven price for the above 530/550 bull spread is defined as $538. The Street happens to assign an implied probability of breakeven of only 30.7%. Further, the probability distribution screener reveals that the chance of AMAT stock triggering the $550 strike at expiration is only about 25.5%.
You don’t need me to tell you that’s super-low and as such, debit traders would likely avoid the 530/550 spread simply because of the low odds of being profitable. Indeed, you wouldn’t have to run an expected value (EV) calculation because it’s obvious you would bleed money over the theoretical long run.
Why are these probabilities so low? Wall Street makes its calculations based on the Black-Scholes family of options pricing models. Under this framework, it’s assumed that AMAT stock will undergo a random walk from now until the expiration date. With each session within this period incurring random behavior, the implied probability of AMAT hitting $550 at expiration comes out to a sterile, modest calculation.
Here’s the question you really need to be asking, though: is it reasonable to believe that Applied Materials stock will indeed undergo a random walk? AMAT only managed to print three up weeks in the last 10 weeks, so no, I don’t believe the next 10 weeks will be random.
Personally, I anticipate nonrandom behavior, primarily because I’m presupposing that institutional players are looking at the long string of down sessions as a buy-the-dip opportunity.
Defending the Nonrandom Presupposition of Applied Materials Stock
Obviously, I have no way of guaranteeing that the immediate future of AMAT stock will be nonrandom. It could be random, that’s ultimately up to the market to decide. But what can be said is that whenever AMAT flashed the 3-7-D quant sequence (3 up weeks, 7 down weeks, downward slope), the historical outlook has been robustly positive.
How robust? Out of the 10 times that the signal has flashed, Applied Materials stock has exceeded the equivalent of the $550 strike a total of six times at the end of week 4 (Sep. 18). Of course, we have to exercise intense caution here because a sample size of n=10 just isn’t scientific. Still, if we deliberately look at the picture from a statistically naïve perspective, we would be looking at a 60% success ratio.
If that were actually the case, the 530/550 bull spread would generate a positive EV over the theoretical long run because you would be winning more money than losing it. But is this inductive model trustworthy?
Here, I’m definitely torn. I do find the 530/550 spread mathematically intriguing because of the historical pattern that has been established. Unfortunately, there’s no way to pin this down with confidence. As I stated, the sample size is too small.
It’s going to come down to your own personal risk tolerance. Because the signal itself is so rare, it’s natural to presume that there’s power or influence in this signal. Again, you’d have to make the decision yourself.
Another Risk to Consider
Unlike other debit spreads that I’ve discussed, this one has a high net cost. Each spread requires a net debit (cash outlay) of $800. That’s not chump change. On the other end of the equation, the maximum profit for this trade is $1,200.
To summarize, if you believe that AMAT stock will travel along a random journey over the next few weeks, you’re looking at a probabilistically risky trade that you should consider avoiding. However, if you anticipate nonrandom behavior, there is an argument that Applied Materials could be underpriced.
It’s amazing what a change of presuppositions can do for you. Just remember, presuppositions are not necessarily valid until they’re actually confirmed by the targeted event itself.
