It’s one of the most surprising developments in politics: President Donald Trump, known for his outspoken views and no-nonsense approach to even the most delicate and controversial topics, basically relented. With the Iran conflict apparently coming to a close, this unexpected dynamic has significant implications for pharmaceutical giant Merck (NYSE: MRK).
At first glance, MRK stock doesn’t appear to have much direct relevance to the Iran war, which threatened to drag the world into a catastrophic depression. However, now that the Trump administration has signaled that it takes the threat of Iran bringing the global economy to its knees seriously, the worst-case scenario is apparently behind us.
Of course, we still must consider multiple variables in this situation. For one thing, both the U.S. and Iran can ultimately disagree on the performance of the underlying memorandum of understanding. If so, Trump may decide to pull the trigger again on military action. Further, Israel’s displeasure at the sudden peace agreement imposes a serious wrinkle on the discussion.
Still, if we were to take the deal at face value, the U.S. has decided that a prolonged conflict with Iran wasn’t worth the economic and societal damage that would likely erupt. As such, previously popular equities have seen a dramatic resurgence of demand — and that may pull public money due to the ‘FOMO’ effect.
It’s no secret that many astute investors would rather consider opportunities that haven’t attracted mass attention. After all, there’s always a risk that too much money going into one place may spark a bearish reaction as the weak hands blink first. That’s where MRK stock comes into the picture. At this point, with the spotlight focused squarely on artificial intelligence and other tech-related names, a company like Merck flies under the radar.
On a year-to-date basis, MRK stock is relatively pedestrian, gaining a little over 8%. Over the trailing month, the security has lost 7% of value, potentially making it an intriguing prospect under the presupposition of mean reversion theory.
Volatility Skew Offers Key Insights for MRK Stock
With a pharmaceutical company like Merck, much of its trading and investment prospect obviously lies with progress on its flagship pipelines. That’s not something that’s easy to predict. But in the interim of these disclosure cycles, we can potentially exploit its technical rumblings.
For options traders, one of the most useful tools to consider is the volatility skew. By definition, the skew showcases implied volatility (IV) across the strike price spectrum of a given options chain. Since IV represents the range of motion for a security at a select strike, a heightened volatility reading incentives traders to hedge the potential move.
In other words, the skew represents an insurance market. At any given moment, a popular security is liable to move either up or down. Since traders aren’t prescient, they must pay a protection premium so that they’re not caught out. Generally speaking, for mature equities, this premium is concentrated on put options, since there’s a greater risk of such stocks losing value quickly rather than vice versa.
Interestingly, though, for Merck stock, the skew features a pronounced “smile” that is unlike what you might usually find with blue chips. Basically, put IV for the near-term July 10 expiration date swings sharply higher at the right-side tail (lower strike price range). This dynamic possibly indicates that smart money traders are assigning at least some probability to a severe negative event.
Still, that’s not the only prominent characteristic of the skew. On the left-hand tail, call IV rises robustly for further out-the-money (OTM) strikes. When looking at this angle, traders are evidently paying a heightened premium for upside convexity.
Broadly speaking, the smart money wants to be protected from catastrophe but it also desires exposure to potential upside swings. More specifically, there’s not much insurance demand for “realistic” strikes or strikes near the plausible trading range of MRK stock. Instead, the protection is centered on the two tails.
To be fair, the skew isn’t necessarily pounding the table on either side of the trade. However, it’s only natural for traders to hedge against downside amid the current geopolitical environment. Fortunately, as cooler heads prevail over the Iran conflict, there’s now demand for enhanced upside. It’s this new framework which I believe speculators may be able to exploit.
Using an Inductive Model to Trade Merck Stock
While the volatility skew doesn’t offer a hard probability regarding future outcomes, we can use an inductive model — a Markov simulation to be precise — to forecast potential results. What aroused my attention to MRK stock is that, unlike other securities, it has suffered a significant slowdown in momentum. Again, under mean reversion theory, we may expect MRK to bounce back.
Notably, in the last 10 weeks, MRK stock has only printed three up weeks, leading to a downward slope. Under this 3-7-D sequence, over the next 10 weeks, the security has a median tendency of ranging between $112.50 and $120 (assuming a starting price of $113.87, Friday’s close). This distribution represents a sizable variance over a random 10-week long position, which would typically range between $113 and $115.50.
Even more enticing, over the next three weeks following a 3-7-D signal flashing, Merck stock has demonstrated a tendency of rising to approximately the $118 level (assuming the same aforementioned starting price). If this pattern were to materialize again, the 114/118 bull call spread expiring July 10 could be in play.
Basically, this trade requires MRK stock to rise through the $118 strike at expiration. If so, the maximum payout would be over 56%. The net debit per spread would be $256. Although this is a bit on the pricey side, you’d be trading a quality blue chip that is statistically stable, given its 60-month beta of only 0.21.
