While global economic challenges ordinarily aren’t helpful for the cruise ship industry, Carnival (NYSE: CCL) may have found a sweet spot. According to Google Finance, CCL stock is benefiting from robust booking demand and continuous balance sheet improvements. Further, Wall Street experts “project steady third-quarter earnings as sentiment suggests a balanced long-term recovery driven by strong pricing power.”
Of course, there are challenges that shouldn’t be ignored. One of the headwinds is that a softened near-term forecast may put a cap on robust upside gains. To be honest, I’m not entirely sure how much of an impact is going to be involved. I find it incredibly difficult to project what might happen over the next few months, let alone a timeline of a year or longer.
What really fascinates me about CCL stock is the near-term picture. As I write this, the ticker has closed on Monday at a price of $27.73. With enough luck, I anticipate a move to $30 next month. Specifically, I’m looking at the 29/30 bull call spread expiring Sep. 18.
For this trade to be fully profitable, Carnival stock must rise through the $30 strike at expiration, which is roughly five weeks away. That requires a move of 8.19% from the time-of-writing price, which is aggressive. For the Sep. 18 options chain, the historical volatility is 36.92%, which is relatively low. While the current implied volatility (IV) reading is 38.71%, there doesn’t seem to be enough “fuel” to justify this debit trade.
Indeed, Wall Street assigns a probability of profit (breakeven) of only 31% for the above call spread. Making matters worse, the probability distribution screener suggests that the chances of CCL stock hitting the $30 strike at expiration is only about 23.94%.
With a maximum payout of just under 186%, there’s no way for the above call spread to generate a positive expected value (EV). Even though you’d be winning a bunch of money on the 24% of the time you are successful, the 76% failure rate statistically ensures that you’d be throwing money into a sinking boat.
But what if the above presupposition is wrong?
Why the Nonrandom Walk is the More Likely Outcome for CCL Stock
When you look at the probabilities that Wall Street provides for your options trades, you should be aware that they’re implied probabilities based on the target security traversing the market through Brownian motion, otherwise known as a random walk. It really has to be this way in order for derivative contracts to clear the market.
Now, the Street utilizes calculations derived from the Black-Scholes family of pricing models. Think of a T-shirt throwing event at a ballgame. Basically, you have a cheer team launching T-shirts bundled like a burrito into the crowd, to the delight of everyone. But here’s the financial detail most people ignore: those T-shirts are almost always unisex and XL-sized.
Why? Because any adult should technically be able to fit into an XL but large-framed individuals wouldn’t be able to fit into a size S. Thus, to keep everyone satisfied — though few are happy — XL T-shirts are launched into the mass of people.
Black-Scholes operates on the same principle. Essentially, the implied pricing of probabilities assumes a random, risk-neutral environment. Obviously, it’s not going to be the most appropriate framework for the plethora of publicly traded companies. But since creating probabilistically biased or privileged models would cause a nightmare in the derivatives market, we’re left with an all-are-satisfied, none-are-happy framework.
So, getting back to Carnival stock, what do the above probabilities mean? Basically, if CCL were to take a random walk journey from the current starting point to the expiration date, there would only be a 24% chance that the ticker would hit the $30 strike.
My contention, though, is that under the current circumstances, CCL stock should incur a nonrandom walk. If you look at the last 10 weeks, the quantitative structure is rather poor: only three up weeks were printed, leading to a downward slope.
It’s not so much that this 3-7-D quant sequence is somehow privileged or special. Rather, in prior manifestations of this signal, CCL stock has demonstrated upward mobility beyond what is expected under random conditions.
If you want to know why this is so, it’s because the equities market is reflexive. As conditions change, major participants respond to the shift, thus influencing the probabilistic outcome of Carnival stock.
Looking at the Bull Spread Through a Different Lens
It must be said that whether you look at CCL stock from a random framework or nonrandom, the proposition is presuppositional. Since nobody knows what the future will hold, we have to rely on certain assumptions to move the central argument forward.
As the Carnival stock options are currently priced, Wall Street is effectively presupposing that CCL will undergo a random walk. I’m presupposing that it will instead undergo a nonrandom walk. Who’s right? We won’t know until we find out. However, I believe that I have a more credible case than simply assuming Brownian motion.
Over the last 38 times that the 3-7-D signal has flashed on a rolling basis since January 2019, CCL stock exceeded the equivalent of the $30 strike price a total of 17 times at the end of week 5 (or roughly equivalent to the Sep. 18 expiration date). That gives us a conditional, observed success ratio of 44.7%.
Obviously, you’re still looking at a probabilistically risky trade. However, consider the EV calculation. If you indeed won full profitability 44.7% of the time, you would multiply 0.447 with the maximum payout of the 29/30 call spread, which is $65. This arithmetical exercise comes out to $29.06. Of course, you would lose 55.3% of the time, meaning you must multiply 0.553 with the net debit paid to enter the trade, which is $35. That comes out to a loss of $19.36.
Over the theoretical long run, you’re looking at a net gain of $9.70.
Risks to Consider
Does a positive EV mean you should go out and buy Carnival stock options right now? Not necessarily because the calculation is a theoretical one. On any given day, for any given trade, anything can happen. That’s true even though there may be an established pattern of positive variance.
Unfortunately, when you run an inductive model on a non-determinative system, you always incur a black swan risk. Just because some trend or pattern has materialized thousands of times does not mean it is guaranteed to recur in the future. No matter what model you use, you will always face this dilemma in the market. It is what it is.
That said, I believe that my presupposition — of order flow imbalances leading to a statistically exploitable response — is more credible than simply assuming that CCL stock will undergo a random walk, regardless of outside conditions. But at the end of the day, it’s up to each individual trader to decide what assumptions align with their own beliefs.
