Perusing strike selections for Texas Instruments (NASDAQ: TXN) bull call spreads for the month of October expiration date, one idea stood out: the 270/280 debit spread. For a relatively low nominal cash outlay of $420, traders can expect a maximum profit of $580 should TXN stock trigger the $280 second-leg strike price. That would translate to a payout of over 138%, which is a tempting proposition.
Of course, Wall Street doesn’t hand out gifts for options traders. As you would expect, there’s a major catch behind the aforementioned spread: the market doesn’t believe it’s a probabilistically reasonable transaction.
To break even on this trade, TXN stock must reach $274.20 at expiration (Oct. 16). On paper, that’s only 4.09% away from Monday’s closing price of $263.42. Given that the current implied volatility (IV) of 38.67% is higher than the historical volatility of 32.89%, combined with a 60-month beta of 1.33, there does seem to be the potential fuel for TXN to hit the necessary threshold.
However, the Street believes that the chance is only 36.3%. Making matters worse, OptionCharts’ Probability Distribution screener suggests that the odds of Texas Instruments stock rising through the $280 strike sit at 29.55%.
You don’t need to run a formal expected value calculation to recognize the dilemma. If you were to trade this exact TXN stock trade multiple times across parallel universes, your portfolio would quickly fall into negative territory. Basically, the full-loss ratio will outnumber the full-win ratio. And that would likely cause financial experts to steer you away from this “opportunity.”
Nevertheless, by accepting these low percentages, we are presupposing that whatever framework is utilized to calculate them is representative of the market reality of Texas Instruments’ stock. I don’t automatically grant that opening premise — and neither should you.
Black-Sholes is Not the Exclusive Solution for TXN Stock
As a standard practice, the pricing of derivative contracts and their implied probabilities stem from the Black-Scholes family of calculations. That’s not necessarily problematic, and that’s not my argument. My point is simpler and more defensible: if you accept Black-Scholes, if you let it be the final arbiter of your trading decisions, you are accepting both the benefits and the drawbacks of its market theology.
This theology is the random walk. Black-Scholes assumes that once the current price (the factual coordinate) and IV are input into its framework, the output mathematically follows a random path. Thus, the model doesn’t necessarily provide the “true” probability of Texas Instruments stock hitting $280 on Oct. 16.
Rather, the presupposition is that if TXN stock follows a random walk from now until the expiration date, the odds of hitting the desired threshold are 29.55%. Therefore, the question isn’t whether the math is correct; it is. The question is whether TXN will truly trade randomly.
It can be possible, for instance, that Texas Instruments stock may trade nonrandomly. And that, I would argue, is a far more reasonable presupposition.
If we were to play devil’s advocate, a random market would suggest that there’s no reason to do any kind of analysis on TXN stock. Think about it — what would the point be if the future of Texas Instruments were completely independent of its past? It would be utterly pointless to pick up a chart or read a quarterly statement because no matter what, TXN’s price discovery would be random.
Aligning with Our Own Beliefs
I’ve been in the financial publication sector for a long time. While my anecdotal observation doesn’t necessarily hold privileged weight, I can tell you with full confidence that I have never met a contributor who genuinely believed the markets were truly random.
In fact, if it were proven that the market is random, it would destroy the whole finpub industry.
Let’s consider the discipline of technical analysis. No matter what you think of it, the main premise behind the technical approach is that chart patterns embed probabilistic inferences about the future. Fundamental analysis claims to be a completely different discipline, but the premise is largely identical: embedded in financial disclosures are probabilistic inferences about the future.
Quantitative-minded analysts also operate by an identical premise: trends found within quantitative data embed probabilistic inferences about the future. What’s the core denominator? That the future is dependent on the (recent and material) past.
Narrative-wise, Black-Scholes does not make that conclusion. Instead, the way the math works out, the future is independent of the past. In practice, this system means that a huge drawdown in TXN stock would have no bearing on its future trajectory.
Does that make sense to you?
If you’re like most traders, the answer is clearly “no.” And that’s the core driver behind why I’m bullish on TXN stock.
Order Flow Imbalance Points to Higher Odds for Texas Instruments Stock
Obviously, recent sessions have not been conducive for bullish traders of TXN stock. In the trailing month, the ticker is down nearly 7%. From a quantitative perspective, we know that in the last 10 weeks, only three of the weekly candlesticks were positive, thus leading to a downward slope across the period. This 3-7-D sequence indicates that 70% of the defined period were net drawdowns.
I think it’s a very rational idea that this severe pessimism would likely change the perception of Texas Instruments’ stock. Some might see it as a falling knife. But others might interpret a discounted opportunity.
In fact, we know that since January 2019, this sequence or behavioral state has flashed 30 times on a rolling basis. We also know that in the fifth week (corresponding to the Oct. 16 expiration date) that TXN stock hit the equivalent of the $280 strike price 12 times or 40%. Moreover, the ticker has hit the breakeven point ($274.20) 17 times or 56.7%.
Are these ratios great by themselves? Not at all. While I haven’t done an expected value calculation, I can tell that the 270/280 bull spread remains a risky proposition. But the point is relative. Under Black-Scholes, few would take the gamble. Under a nonrandom, path-dependent process, there’s a rational case for being aggressively bullish on TXN stock.
The Final Word on Options
It’s also worth reminding ourselves that we’re not limited to taking an aggressive bet. More conservative traders may consider the 260/270 bull spread (also expiring Oct. 16). Here, Wall Street’s probability of breaking even improves to 46.4%. But the main drawback is the payout, which plummets to 62.6%.
But notice something interesting here. Even with the safer transaction, the probability of breaking even on the 260/270 spread is lower than the probability of breaking even on the 270/280 spread when viewed from a path-dependent framework. Therefore, a change of presupposition can radically alter assumed risk.
To be clear, path dependency doesn’t necessarily mean that it’s the truth. However, I would argue that given the current quantitative structure of TXN stock, this presupposition is more reflective of reality than random path independence.
