It may be an obvious trade but with conflict still raging in Iran, oil stocks are back in vogue, driving up stalwarts like Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX). While these names are still interesting, I’m more interested in the speculative opportunity behind major energy giant Petrobras (NYSE: PBR). Thanks to its low share price and wild market movements, there’s a chance for late-to-the-game options traders to scalp serious profits.
What’s the premise behind my bullishness for PBR stock and the oil market in general? It’s not simply that the Iran crisis is back on the geopolitical frontline. Sure, that is a fundamental factor but it’s also a well-known, well-digested news item. Reading yesterday’s article from Reuters is not going to provide you a trading edge today.
Instead, the premise is market structure; specifically, how certain structures signal a probability of an upcoming transition. Philosophically, I rely heavily on Markov chains. The question is as follows: given a particular market structure (or behavioral state), what is the probability of it transitioning to another, different structure?
Again, I don’t really care about the fundamentals or the technical — they provide some descriptive context of how a ticker like PBR stock ended up where it is. But I don’t believe that such knowledge inherently provides alpha. Frankly, it’s more like delusions of grandeur. Think about it: why would reading yesterday’s news or drawing arbitrary lines on a chart consistently lead to exploitable mispricings?
Instead, my philosophy revolves around the concept that future market returns represent an independent variable. What’s my evidence? Well, consider the opposite argument. The assumption that asset returns are completely Independent and Identically Distributed (I.I.D.) — or a pure, memoryless random walk — is fundamentally refuted by theoretical econometrics and empirical market data.
In other words, what happens tomorrow depends on what happens today. That’s the core Markovian philosophy when applied to the financial markets. It’s here that I’m in full agreement, actually, with fundamental and technical analysts.
But the difference is that I use an algorithm to measure the outcomes of these dependent variables. Enticingly, my algorithm points to a potential bullish opportunity in Petrobras stock.
In earlier StockEarnings.com articles, I made specific trading ideas for Exxon Mobil and Petrobras. For the former, I discussed the opportunity present in the 138/141 bull call spread expiring July 31, while for the latter, I focused on the 17.50/18 bull spread expiring July 31.
Unless the floor decides to drop out, those trades are well on their way to full profitability. What’s compelling is that I used the exact same model to formulate those options strategies. This doesn’t mean that my model is the absolute truth because that’s not true — I get things wrong all the time. However, what you see is what you get with me. Whatever the trading idea, it’s going to come from the same methodology.
Indeed, the main reason why I’m interested in Petrobras stock at this hour is that the security just flashed an exploitable trading signal. In the last 10 weeks, the number of up weeks and down weeks was split 50/50. However, the overall slope was negative across the 10-week period, which represents a unique situation.
Since January 2019, there have been 375 rolling 10-week sequences. Of this figure, 63 comprised of the above 5-5-D quantitative signal. Here’s where the fun part comes in. If we were to look at where PBR stock may end up over the next 10 weeks using an aggregate of all quant sequences, the expected forward distribution would land between $18.95 and $19.30 (assuming a starting price of $19).
With probability density only peaking at $19.08 or thereabouts, the expected performance when buying PBR stock randomly offers practically no advantage. When you factor in transaction costs, you would risk a negative expectancy over time.
However, when you buy PBR stock after it flashes the 5-5-D sequence, you may expect a forward 10-week distribution between $18.50 and $20.40, with probability density peaking at $19.48. That’s not much better than the aggregate baseline but keep in mind that the positive variance isn’t orderly and linear.
Specifically, on the fourth week following the flashing of the above signal, the median endpoint is a move up of approximately 4.74%. That would put PBR stock at the equivalent of around the $19.90 price point at the Aug. 21 expiration date.
Putting Two and Two Together
So, assuming you believe the above inductive model, there’s an enticing argument to consider buying the 19.50/20 bull call spread expiring Aug. 21. Attractively, the net debit per spread is only $20 so you can penny-pinch your exposure to this trade. Should Petrobras stock rise through the second-leg strike ($20) at expiration, the maximum payout is 150%.
What does that mean? You pay $20 for the bull spread and if PBR stock hits $20 on Aug. 21, you collect $30 of profit.
That may sound too good to be true, and this is where Wall Street comes into play. Currently, this spread’s breakeven price is $19.70, which is considered a low-probability affair. In fact, the market assigns a probability of profit of only 36.6%. It’s here that many, if not most, conservative traders ignore the deal.
Nevertheless, the core mathematical tension is that this probability stems from the Black-Scholes model, which assumes that future stock outcomes are independent variables. I’m not convinced by this assumption because the overwhelming evidence (in my opinion) points to future returns being dependent variables; that is, the future outcome depends on or is heavily influenced by immediate prior outcomes.
As a quick example, if a security falls 10% in a day, it’s most likely going to react differently than if said security jumped 10% instead. Black-Scholes, as a risk-neutral, lognormal environment, structurally treats both circumstances the same, thereby exposing options priced using this model to potential distortions.
That’s actually my argument, that the options pricing for PBR stock is distorted in your favor. Of the 63 times that the 5-5-D signal has flashed, the ticker has exceeded the $19.70 breakeven price a total of 32 times. Therefore, the conditional, observed probability of profit could be 50.8%. If true, you’re getting over 1,400 basis points of free odds.
