At first glance, microcontroller specialist Microchip Technology (NASDAQ: MCHP) won’t seem very appealing, especially to those who are risk-averse. I can’t blame them. Over the trailing month, MCHP stock has dropped more than 21%. Generally speaking, the ticker has been on a downward slide since early May and the latest escalation in Iran doesn’t exactly bode well for global stability.
Nevertheless, an argument exists that MCHP stock could be due for a reversal of fortunes. Fundamentally, it appears that Microchip stands on solid ground. However, the popular consensus is that the security has suffered from a textbook “sell the news” post-earnings reversal.
Yes, the latest fiscal fourth-quarter results were strong, with the company posting a 35.1% revenue lift on a year-over-year basis. So, what’s the problem? Basically, the explanation is that because the long-awaited recovery in industrial and automotive microcontrollers was already baked into the share price, institutional money used the strong print as a liquidity window to lock in profits, triggering a sizable fade.
Other analysts will point to the sky-high valuation metrics that MCHP stock printed during its heyday. In late June, Microchip was still trading at a price-to-sales ratio nearing 11x, whereas the semiconductor industry average landed at 8.58x. I’m not a big fan of these rearward-looking financial ratios but from a comparative standpoint, you can see why many in the market wanted to trim their exposure to a statistically bloated entity.
Still, if the smart money has anything to say, it does seem as if optimism is steadily gaining for Microchip stock. When you look at the volatility skew for the Aug. 21 options chain, the chart shows a positive-leaning “smile.” What that means is that the implied volatility (IV) for out-the-money (OTM) calls is greater than the IV for OTM puts.
In other words, while traders are paying a premium for downside protection (resulting in elevated IV on the left or put side), they are prioritizing upside convexity, as evidenced by the IV spike for calls (on the right side). This framework doesn’t guarantee upside for MCHP stock but it demonstrates that the hedging bias is more aligned with a net-bullish posture.
An Enticing Quant Signal Adds Potential Fuel for MCHP Stock
Although volatility skew may provide insights as to how other traders are managing uncertainty, it doesn’t tell us anything about what is likely to happen. For example, just because other people are loading up on auto insurance premiums doesn’t necessarily mean that they are more likely to suffer an accident; they merely fear that a financially disastrous accident may occur.
It’s the same philosophy with Microchip stock. Even if we had perfect knowledge of trader hedging activities doesn’t necessarily mean that MCHP will trade into the implications of the hedge. Instead, I believe we need to condition forward probabilities based on specific, quantitative signals.
Some might question why quant signals matter and it’s a fair inquiry. I would point to the nature of the modern equities market. Currently, price discovery is largely a consequence of major funds and institutions running algorithmic, rules-based trading protocols. This technology is necessary because of the latency penalty. If you’re late in absorbing publicly disclosed material news, you’re left paying a volatility premium of the in-demand security or derivative.
To extend this theory, it’s reasonable to believe that such algos will view quality enterprises like Microchip suffering an extended downturn as a discounted opportunity. If so, new buyers may help bolster MCHP stock, right at the time when the weak hands have been washed out. This newfound pressure could lead to a positive mean reversion, which is perhaps why MCHP’s volatility skew shows net upside convexity.
Quantitatively, we know that in the last 10 weeks, Microchip stock has printed only three up weeks, leading to a downward slope. This 3-7-D sequence — which has materialized 37 times on a rolling basis since January 2019 — has historically led to an outsized performance. Over the next 10 weeks, the expected distribution of median outcomes is between $75 and $102 (assuming a starting price of $80.96), with probability density peaking at around $91.
As a random baseline, the expected forward 10-week distribution of MCHP stock is between $80.50 and $82, with peak probability density near $81.10. We’re talking about an average positive variance of 12% when comparing peak to peak, which is stunning.
What’s more, the performance variance between the signal and the baseline is generally orderly, scaling up with each passing week in the distribution. As such, there are many options here (no pun intended).
Going for a High-Probability Setup
Despite the many choices available, I’m really digging the 80/85 bull call spread expiring Aug. 21. While this trade doesn’t have the maximum payout firepower of other ideas — offering “only” 100% — the statistics undergirding the trade add to the temptation.
Enticingly, the 80/85 bull spread’s breakeven price is $82.50, which I believe to be a very reasonable target. However, Wall Street currently pegs the probability of profit (the likelihood of Microchip stock rising to $82.50 at expiration) at only 46.8%. Empirically, these odds should be higher.
I say that because of the 37 times that the 3-7-D quant signal has flashed, it has risen above the equivalent of the $82.50 breakeven price a total of 24 times on week 5. If we take this observation at face value, the probability of profit should be 64.9%. That’s over 1,800 basis points of “free” odds in your favor.
It’s a fancy way of saying that the 80/85 bull spread is underpriced relative to the historical risk incurred in MCHP stock under the aforementioned setup. Even better, during the times that the quant signal flashed, MCHP rose above the equivalent of the $85 second-leg strike a total of 21 times on week 5.
Basically, there may be a 56.8% chance that this spread reaches full profitability, not just breakeven. Again, we have to be careful because my model isn’t guaranteed to be the sole arbiter of truth. But if the implications are accurate, this options spread for Microchip stock could be a remarkable steal.
