I’m not a big fan of earnings disclosures and trading on what might happen. As such, I’m not exactly eager to dive into the supposed details of GE Aerospace (NYSE: GE), which is scheduled to release its third-quarter numbers on Oct. 20. But because GE stock has been on a disappointing run over the past several weeks, the ticker may be relatively cheapened.
If so, I’m looking at a contrarian options-based strategy. To be sure, GE Aerospace stock is a highly risky name, not only for its recent volatility but also due to broader economic uncertainty. Still, if market mechanics are anything to go by — as in, the idea that discounted equity shares of strong, relevant companies can potentially mean revert — GE stock may be worth consideration.
According to Google Finance’s summary sheet, GE Aerospace is benefiting from robust demand for commercial aviation services. Specifically, “[s]trong global airline traffic keeps engine utilization high, translating to steady, high-margin services revenue and shop visits for the commercial engines business.” In addition, a “massive multi-billion-dollar backlog provides long-term revenue visibility, as commercial carriers and defense departments secure production slots years into the future.”
On the other hand, the main bearish view relates to persistent aerospace supply chain constraints. Google Finance writes that “[l]ingering material shortages, casting bottlenecks, and skilled labor deficits continue to slow engine production delivery rates below optimal industry demand levels.”
Overall, though, there does seem to be careful optimism heading into Q3. Because of this sentiment, those who are speculatively bullish on GE stock may consider the possibility of a buy-the-rumor, sell-the-news type of trade.
Honestly, the bottom line is that no one knows for sure what’s going to materialize during the company’s financial disclosure. Even if the numbers were awesome, the market could still freak out by reading between the lines of guidance or some other obscure detail.
Therefore, it may be prudent to consider an options spread for the Oct. 16 expiration date.
Warning: The Odds Aren’t Great for GE Stock
Suppose we were to nail down the time period — that doesn’t say anything about which specific trade to target. So, based on similar circumstances that GE Aerospace stock has found itself in right now, I believe the psychologically significant $350 level may be in play. This level previously acted as technical support for prior sessions, so it doesn’t seem completely unreasonable.
If we accept this assumption, the 340/350 bull call spread expiring Oct. 16 would appear to be an interesting candidate. For a net debit (cash outlay) of $405, the speculator will be hoping for GE stock to rise through the $350 second-leg strike price at expiration. A successful triggering would generate a maximum profit of $595, a payout of nearly 147% at the time of writing (Sept. 2 close).
However, a big problem exists with this transaction: Wall Street’s options pricing mechanism gives GE Aerospace stock low odds for triggering the breakeven price of $344.05. At only 33.9%, it would seem that you would be merely throwing away the $405 net debit. Adding to the point, OptionCharts’ Probability Distribution screener rates the probability of GE hitting $350 at expiration at only 28.01%.
We don’t need to formally run an expected value (EV) calculation to recognize our dilemma. Since we’d be winning full profitability at only 28% of the time (and breaking even a little over one-third of the time), if we ran this exact trade across multiple parallel universes, we would quickly go underwater.
Frankly, most financial experts will sway you far away from this trade because the circumstances don’t look enticing. But it’s also important to understand why that is the case.
Not All Presuppositions are Equal for GE Aerospace Stock
Primarily, the concept that has to be drilled into your head is that all forecasts of the unknown future are presuppositional. We won’t know until we know. In other words, the probabilities that you just saw above are not necessarily the absolute Gospel truth. Instead, they are projected calculations printed within a specific framework.
That framework is the Black-Scholes model. This formula assumes that GE stock will undergo a random walk between now and the expiration date, with the current implied volatility (IV) serving as the constant “fuel” throughout the journey. Subsequently, the aforementioned odds are derived assuming randomness and risk-neutrality.
Personally, I don’t believe that this framework is correct. Quantitatively, GE Aerospace stock incurred several negative weekly candlesticks; in fact, over the last 10 weeks, only three of the weekly sessions were positive, thus leading to a downward slope across the period.
Source: StockCharts.com
Now, this 3-7-D quant sequence is just a static snapshot of an order flow imbalance, where negative sessions overwhelmingly dominate positive sessions. In other words, the current market structure for GE stock is bearish, which implies that at least some weak hands have been flushed out.
However, it’s also possible that, because of this flushing, professional investors and traders may view GE stock as a temporary discount. If so, there is an emotional influence driving contrarian, bullish interest in the ticker — that’s not random behavior but nonrandom.
Taking an Inductive View
Earlier, I said that I was targeting the $350 strike price. I didn’t just come up with that number; instead, I used inductive reasoning. Looking at the historical data of GE stock, we know that the 3-7-D signal has flashed 23 times in the technical charts since January 2019. Of this tally, GE has risen above the equivalent of the $350 strike price 11 times on week 6 (which roughly corresponds to Oct. 16 expiration date).
To be fair, we’re talking about a small sample size. As well, the inductively calculated odds aren’t superb. Still, the conditional probability of full profitability could be 47.8%. What’s more, in the week prior, the success rate comes in at 56.5%.
With a 147% payout, this GE Aerospace stock call spread would theoretically have a positive EV over the long run. It doesn’t guarantee success, obviously, but the chances are now much more rational than they were under the Black-Scholes presupposition.
Of course, the inductive model is always subject to the black swan risk: a previously observed trend won’t necessarily determine its materialization in the future. However, I would argue that the random walk assumption is highly unsatisfactory given the order flow imbalance. Therefore, if you can handle the risk, take a close look at GE stock.
