It hasn’t been an economically favorable situation for the retail giant Costco (NASDAQ: COST). Nevertheless, despite obvious domestic and global pressures, steady consumer spending and stable e-commerce metrics have represented positive catalysts for COST stock, according to Google Finance’s summary sheet. Therefore, COST’s recent underperformance could be an opportunity to pick up exposure on the cheap — especially for risk-tolerant options traders.
Fundamentally, Costco stock benefits from two major tailwinds. First, the company enjoys a resilient membership model and high retention. Per Google, the latter stats are hovering near historic highs, which is significant considering the broader economic challenges. Further, “[a]nalysts expect the subscription-based recurring revenue model to provide predictable cash flows and cushion the company against potential consumer spending slowdowns over the upcoming quarters.”
On another note, Costco is aggressively pursuing its international expansion strategy. Part of the reason COST stock enjoys consistent upswings is related to its steady pace of warehouse openings in global markets. “This international footprint scaling is projected by market analysts to drive long-term top-line growth and diversify revenue away from mature domestic regions.”
The one obvious headwind for COST stock is the premium valuation multiples. Google Finance notes that the asset “trades at a significant premium compared to its retail peers.” Analysts argue that this leaves Costco stock with little margin for error should growth metrics or margins incur even minor slowdowns.
Still, one could plausibly make the argument that the positives outweigh the negatives. Subsequently, the recent fading of COST stock — where the ticker lost roughly 4% in the trailing five sessions heading into the long holiday weekend — may be a potential mean-reversion candidate.
Obviously, not all falling securities bounce back; otherwise, trading would be easy. But in this case, Costco stock could legitimately be viewed favorably by contrarians, especially if it appears that at least some weak hands have been flushed out.
Understanding the Role of Randomness in Risk Management
Before we get into a discussion of why COST stock could bounce up from its current malaise, it’s important to understand that there are two main presuppositional philosophies at work here. Because the future is unknown — especially in a reflexive environment like the equities market — traders need to have a presupposition to get the argument moving forward.
Under Wall Street’s options pricing mechanism, an underlying assumption exists that the target security will undergo a random walk. Imagine the market as a long series of compounded coin tosses. In this scenario, you would be disincentivized to take a heavy risk. Why? Simply because you wouldn’t have predictive control of your outcomes.
On the other hand, if the coin were somehow weighted differently, such that the probabilities were 60/40 rather than 50/50, the risk management calculus would likely change. That’s because you now have some intelligence that the outcome will be biased toward a particular side.
In this case, the framework is nonrandom, and this dynamic could potentially be exploited in your favor.
Casting Doubt on the Random Walk Framework of COST Stock
Turning back to Costco stock, the ticker has quantitatively suffered a serious decline. In the past 10 weeks, only three of the weekly candlesticks were positive, thus leading to an overall downward slope across the period. While this 3-7-D quant sequence is merely a statistic snapshot in time, it’s the market’s response following this signal that is important.
Using historical data going back to January 2019, we can inductively infer that the median endpoint target for COST stock by mid-October is just shy of the $960 level. For aggressive speculators, they may be interested in the 950/960 bull call spread expiring Oct. 16.,
On paper, this trade appears very attractive. For a net debit (cash outlay) of $445, speculators will be hoping for Costco stock to rise through the $960 second-leg strike price. If it does, the maximum profit would be $555, a payout of almost 125%.
But there’s a big catch with this call spread: Wall Street assigns a very low probability of success.
Consider the breakeven price of $954.45. It would take COST stock to rise 4.23% from the time of writing to reach this threshold. Given a currently modest implied volatility (IV) of roughly 24%, the chance that the spread will break even is only 30%. What’s worse, OptionCharts’ Probability Distribution screener indicates that the odds for triggering the $960 strike at expiration are only 28%.
These are terrible metrics, which means that based on an expected value (EV) calculation, you should probably avoid the 950/960 spread. You would simply be projected to lose more money than win over the theoretical long run.
However, these probabilities assume that Costco stock will undergo a random walk between now and the Oct. 16 expiration date, with the current IV serving as the constant “fuel” across the journey. That might not be the most accurate framing because of the aforementioned bearish order flow imbalance.
Supporting the Idea of a Nonrandom Walk
Primarily, the main theory behind the nonrandom walk for COST stock is that the likely flushing of weak hands may motivate institutional investors to consider picking up the relatively discounted shares. It’s not an outrageous idea fundamentally, as Costco has been a solid enterprise despite challenging economic circumstances.
More importantly, it’s not just vibes but the concept is backed by empirical data. Since January 2009, the 3-7-D quant sequence has flashed 35 times on a rolling basis. This shows just how rare the signal is, since there have been 903 rolling 10-week sequences during this period. You’re looking at a possible buy signal that only flashes less than 4% of the time.
However, when it does materialize in the charts, COST stock tends to rise noticeably higher on the sixth week, which approximately aligns with the Oct. 16 expiration date. Specifically, during that week, COST has exceeded the $960 strike a total of 17 times, or a success ratio of 48.6%.
No, that’s not exactly great but that’s a much better statistic than 30%. At this point, you’re potentially taking a more rational wager than something that’s a longshot. Also, keep in mind too that Costco stock has exceeded the breakeven price of $954.45 a total of 21 times or 60%. Subsequently, the 950/960 bull spread might be more intriguing than initially meets the eye.
That’s not to say that the wager has confidence backing it. Like with anything in the market, the inductive inference is an educated guess — and that’s never foolproof. However, because of the extensive data, COST stock might be worth investigating for aggressive risk-takers.
