There’s no such thing as a free lunch, and that especially applies to Wall Street. So, when I came across a compellingly discounted debit-side call spread for Advanced Micro Devices (NASDAQ: AMD), my first response was skepticism. And while I still believe the following proposition is risky, there’s an empirical case to consider for AMD stock.
Let’s set up the play. For the mid-September session, market makers were offering the 510/520 bull call spread expiring Oct. 16 (roughly five weeks away) for only $460. Should AMD stock rise through the $520 second-leg strike on expiration, the maximum profit would come out to $540. This would translate to a payout of over 117% — not bad for a month’s worth of “labor.”
It gets even more enticing, at least on paper. For Advanced Micro Devices stock to hit the full-profitability target ($520 on Oct. 16), the ticker would only need to rise 3.13% from Tuesday’s close. I don’t want to sound presumptuous, but that seems like a very reasonable forecast, considering the underlying boom in artificial intelligence.
But there’s a catch — of course there is. Based on the Street’s options pricing mechanism, the probability of merely breaking even on the above call spread at $23.30 is only 44.5%. It’s not the worst ratio out there, but it does make you pause since we’re talking about a coin flip just to get a draw.
Worse yet, under the Black-Scholes model, the probability of AMD stock triggering the $520 level on expiration is only 39.5%. If you were to run an expected value calculation, your portfolio would quickly sink as the number of losses would eventually exceed the number of wins.
Therefore, many speculators would likely be convinced — based on the probabilistic evidence — to walk away from the trade. But what if I told you that you don’t necessarily need to abide by the first presupposition you encounter?
Prosecute the Claims Before Deciding on AMD Stock
Imagine for a moment that you’re enjoying a leisurely stroll on the beach trail. Suddenly, an apologist from Religion X admonishes you and says that you’re destined for perdition unless you exclusively worship their deity. Chagrined, you go a bit further until another apologist — this time for Religion Y — makes another exclusive claim about their faith.
Once you hear the same message from a representative of Religion Z, it should become readily apparent that there are three basic conclusions: one of these religions is telling the truth, some are telling partial truths, or they’re all unfounded.
Either way, if you’re intellectually curious, you’re going to investigate the claims. You wouldn’t just accept the truth claims of one of the three religions. This healthy auditing should then apply to Black-Scholes. Yes, they have presented a mathematical case for the likelihood that Advanced Micro Devices stock will hit certain thresholds. That by itself doesn’t mean the model is the exclusive arbiter of truth.
Arguably, the most problematic presupposition undergirding Black-Scholes is the random walk. Basically, the core driver of future price discovery under this model is that AMD stock will trade randomly between now and the expiration date. If it is true that future valuations are primarily derived from a random, risk-neutral environment, then yes, the aforementioned probabilities are legitimate.
But it should be this presupposition of a random walk that needs to be demonstrated. Because what necessarily follows from this setup is that the future is independent of the (material) past. However, I don’t find this argument compelling because there would be no reason to read investment and trading articles.
Think about any finance article ever published. They all reference something that happened in the past to make an inference about the future. That’s not a random walk — that’s very much a nonrandom walk.
Nobody ‘Really’ Believes in Black-Scholes
At the core, a technical analyst believes that past price patterns embed probabilistic information about the future. A fundamental analyst believes that past financial trends help forecast a forward-looking outcome. And a quantitative analyst believes unique signals within past empirical data provide a composite picture about the future trajectory.
What’s the common thread? Practitioners of these disciplines believe that the future is dependent on the past. Quants in particular believe in path dependency. Basically, they assume that the path that got a security to its present level matters in attempting to decipher where it may go next.
That’s the primary reason why I dispute the random-walk framework. In the case of AMD stock, in the last 10 weeks, the ticker managed to print six up weeks. Ordinarily, a bullish order flow imbalance would suggest an overall upward slope across the total defined period. However, AMD found itself in a rather unique situation where the overall slope was downward.
How rare is this 6-4-D (6 up, 4 down, downward slope) sequence? Going back to January 2009, this structural state has only materialized 26 times on a rolling basis. Over the next five weeks (again, roughly coinciding with the Oct. 16 expiration date), the median terminal expectation is for Advanced Micro Devices stock to hit $531.
Subsequently, there is a case — under this model — for speculators to consider the 520/530 bull spread, which currently features a maximum payout of nearly 141%. Wall Street sees such a move (to $530 on Oct. 16) as unlikely, assigning it a 34.6% probability.
Under the presupposition of a nonrandom walk, the odds could actually be 50%. Not great, obviously, but significantly better than 34.6%.
Why the $520 Strike is Intriguing
Despite the higher payout of the 520/530 spread, I still find the 510/520 spread more intriguing between the two. In part, that’s because the low sample size of 26 occurrences of the signal is not large enough to engender much confidence. Because of this reality, a more conservative exposure would seem to be ideal.
Usually, though, when you do become more conservative in the spread choice, the potential reward becomes heavily capped. That’s not necessarily the case for AMD stock when stepping down to the $520 strike.
Under my nonrandom model, the odds of hitting the above target on expiration improve to 57.7% (or 15 hits out of 26 occurrences). That’s close to a 60% success ratio, which arguably alters the risk perception of AMD stock.
No one’s claiming that Advanced Micro is a no-brainer at this juncture. But when observing the situation from a presuppositional lens that more likely aligns with market reality, it’s difficult not to get excited about AMD stock.
