Yum! Brands (NYSE: YUM) is effectively a balancing act when it comes to the business proposition. Naturally, the fast-food giant has struggled from economic pressures, which impact both overall growth and profitability (due to higher costs). At the same time, strategic pivots have helped keep the lights on. But despite what should be a relatively stable equilibrium, YUM stock has not been particularly attractive to bulls.
Since the start of the year, heading into the Labor Day weekend, YUM had slipped slightly below parity. In the trailing month, YUM stock has gone nowhere. Looking at the close of July 7, Yum! Brands has lost 10% of equity value. Given that we’re not talking about a highly mobile name, the red ink has left many options traders worried.
Still, if you were to give a fair crack at the fundamentals, the picture may not be so dire. Let’s start with the bad news. According to Google Finance’s summary sheet, domestic consumer spending has represented a persistent headwind. These challenges — especially related to lower-income households — have strained same-store traffic metrics.
On another front, labor and operational cost pressures have hurt sentiment toward Yum! Brands stock. “Elevated wage inflation and supply chain friction within key operating regions continue to challenge operating margins, capping the company’s near-term profitability upside.”
Fortunately, some positives exist, primarily a robust digital and delivery infrastructure. Google Finance states that, “[s]ustained investments in digital ordering, loyalty programs, and omnichannel delivery ecosystems continue to drive order frequency and ticket sizes globally across its core restaurant concepts.”
As well, Yum is leaning heavily into its international growth strategy, where sustained momentum in emerging markets offers strong business diversification. Also, looking abroad has helped offset lighter domestic spending, which suggests that YUM stock may have some legs here.
It may come down to a half-glass-full narrative — and that could play into speculators’ hands.
Order Flow Imbalance Highlights a Contrarian Trade for YUM Stock
Basically, with the fundamental pros and cons arguably canceling each other out, there may need to be an outside catalyst to move the discussion for Yum! Brands stock. I believe this catalyst is order flow imbalance: over a given period of time, YUM has simply inked more negative sessions than positive.
Under this view, it’s possible — and some might say plausible — that at least some portion of the weak hands have been flushed out. This flushing should, in theory, make upside resistance less sturdy because the dominant profile of the market right now is toward bearishness. However, the mean-reversion argument here focuses on the potential fact that for YUM stock to continue falling requires additional bad news.
It’s here where the contrarian might look at the situation favorably: if there isn’t much pessimism to integrate into the Yum! Brands stock price, it’s reasonable to believe that the bad news could be baked in. This forecast assumes, of course, that nothing silly happens between now and your targeted exit date. If it doesn’t, there’s an empirical basis for bullishness for the fast-food specialist.
Specifically, YUM stock has printed only three positive weekly candlesticks in the past 10 weekly sessions (again, heading into the Labor Day weekend). Using inductive reasoning from historical share price data, under this 3-7-D quantitative sequence, we can estimate that YUM may rise about 4.8% as a median expectation by the Oct. 16 expiration date.
Let’s just assume for a moment that this forecast is accurate. With this inference, there are several ideas to consider in terms of multi-leg options spreads. For the daring, I’m tempted by the 155/160 bull call spread expiring Oct. 16.
This transaction requires YUM stock to rise through the $160 second-leg strike at expiration. If it does, the net debit (cash outlay) of the trade of $220 will turn into a maximum profit of $280, a payout of over 127%. That might look like a solid play until you realize that Wall Street views the wager as a low-odds affair.
Random Versus Nonrandom Assumptions
Using the standard Black-Scholes model of options pricing, the machinery pegs the probability of Yum! Brands stock triggering the breakeven price of $157.20 at expiration at only 30%. Making matters worse, OptionCharts’ Probability Distribution screener calculates that the odds of YUM hitting $160 are only 24.83%.
You don’t have to spend too much time running an expected value (EV) calculation to see the problem here. Since you would be expected to fully win less than a quarter of the time — and only break even 30% of the time — your eventual losses will dwarf your wins over the theoretical long run.
To be fair, an EV calculation is only a theoretical exercise where an identical trade is placed across multiple parallel universes. At any one moment, you could win big despite the odds being against you. But because the stated probabilities are indeed so low, most financial experts would likely advise you to walk away.
Nevertheless, you should know how the above probabilities are calculated in order to make an educated decision. Relatively few realize that the presupposition undergirding Black-Scholes-based models utilizes random walk frameworks; that is, YUM stock is calculated to trade randomly between now and the expiration date, with the current implied volatility (IV) serving as the constant “fuel” throughout the journey.
However, I disagree wholeheartedly with the random walk presupposition because of the aforementioned order flow imbalance. Since January 2009, whenever the 3-7-D signal has flashed in the charts (48 times), YUM stock has hit the equivalent of the $160 strike price on week 6 (roughly Oct. 16) a total of 23 times.
Based on the conditional, observed data, the probability of full profitability may be closer to 47.9%. That might not be the greatest ratio ever. But also, keep in mind that Yum! Brands stock has also exceeded the $157.20 breakeven price 29 times on the projected Oct. 16 date.
Thanks to a shift in presuppositions to a nonrandom framework, the breakeven rate may be 60.4%. If that’s true, I believe there’s an incentive to consider the 155/160 bull spread, as opposed to a more permissive but lower-reward spread.
A Final Caveat to Consider
I don’t want to come off as completely trashing Black-Scholes or random walk models. Because the equities market is reflexive, there’s no way to know for certain how YUM stock — or any other ticker — is going to react. It’s really a guessing game.
In my defense, I believe that observing patterns within an inductive model can help us understand what is likely. But even here, there are epistemological challenges; mainly, that an observed trend in the past is not guaranteed to repeat in the future.
Ultimately, my point is that we’ve seen the 3-7-D signal play out bullishly more times than not since January 2009. That’s arguably a very large dataset that gives us some confidence. Still, whether one finds the argument convincing is left as a personal decision.
