One of the big problems with sitting on the sidelines for a massive financial giant like Morgan Stanley (NYSE: MS) is that once the big move has been baked in, the opportunity for upside is naturally limited. Because MS stock isn’t known for robust volatility, investors may need to consider looking elsewhere due to the lack of potential growth expansion.
That’s pretty much the overall take these days for Morgan Stanely stock. Sure, as Google Finance’s summary sheet has noted, Wall Street has been impressed with the financial firm’s massive second-quarter earnings beat, along with an increased dividend and a fresh $20 billion buyback program. Strategic infrastructure expansion and stability in its wealth management business have helped catapult MS stock to a year-to-date performance of roughly 21%.
However, Google points out that the bear case involves valuation concerns. It’s not so much that MS stock is overvalued. But analysts have noted that the current share price is in-line with its fundamentals, which doesn’t really help the long-side investment thesis. Yes, the organization has proven to be a heavy-hitter amid this challenging economic framework. Yet with this good news priced in, the ceiling for MS has apparently gotten shorter.
Does that mean options traders should stay away from this name? Given the difference in priorities for participants in the derivatives market, short-term speculators may want to give MS stock another look.
Order Flow Imbalance May be Signaling an Opportunity for MS Stock
Looking at the technical chart for Morgan Stanley stock, it’s not too surprising that it has entered a consolidation phase recently. Between late March and mid-June, MS enjoyed about a 40% swing higher. That’s massive for any blue chip but utterly gargantuan for a big bank.
What’s interesting about the aforementioned rally is that, right before it happened, MS stock may have issued a quantitative tell: in the prior 10 weeks, it had only printed three up weeks, leading to a downward slope. Essentially, this 3-7-D signal represented an order flow imbalance, with the bears overwhelming the bulls.
However, it’s difficult to keep an industry stalwart suppressed indefinitely. With the weak hands flushed out of Morgan Stanley stock, it’s possible that the bulls moved in. Keep in mind that the Q2 earnings disclosure happened in mid-July so that wasn’t the catalyst for the ticker.
Now, I’m bringing up this order flow imbalance because it’s happening again. If you look at the weekly technical chart, the 3-7-D signal has just flashed. If we can get even a little bit of a pop, it wouldn’t be irrational to believe that MS stock could hit the psychologically significant $230 level.
If so, the 220/230 bull call spread expiring Oct. 16 may be in play. This trade requires MS stock to rise through the $230 strike at expiration, which would convert the $440 net debit (cash outlay) to a $560 maximum profit, a payout of over 127%.
There’s just one problem here: Wall Street assigns very low odds of success.
Why the Random Walk Might Not Cut It for Morgan Stanley Stock
If you look at the supplied stats for the Oct. 16 220/230 bull spread, they aren’t flattering. For the trade to break even, MS stock must hit $224.40 at expiration. Unfortunately, the chances of doing so — per the Street’s option pricing mechanism — are listed at 34.2%.
What’s worse is the probability of full profitability. According to OptionCharts, its Probability Distribution screener rates the odds of Morgan Stanley stock triggering the second-leg strike at expiration at only 26.90%.
You don’t have to run a formal expected value (EV) calculation to see the problem. Over the theoretical long run, you’ll win full profitability about 27% of the time, meaning $150.64. But you’ll be losing about 73% of the time, translating to $321.64 down the tube. If you keep hitting this exact same trade under these conditions, you would be expected to lose $171.
Of course, with the debit call spread, so long as the target stock doesn’t dip below the breakeven price, you can make a profit. But because even this threshold only carries a 34% success rate, the overall numbers don’t seem enticing.
Still, you must realize that these probabilities are implied based on the Black-Scholes model. Without getting bogged down with the math, this basically means that there’s an underlying assumption that Morgan Stanley stock will undergo a random walk between now and the expiration date. If indeed the trajectory is random, these odds would make sense.
I just don’t believe that this will be the case.
Traders Should Expect a Nonrandom Walk
I want to be crystal clear that there’s no guarantee that MS stock will reach the aforementioned $230 strike on Oct. 16. Still, I didn’t pull this number from the sky. Instead, I noted that of the 21 times that the 3-7-D signal has flashed in the technical charts since January 2019 (on a rolling basis), MS has triggered the equivalent of the $230 strike at expiration a total of 11 times.
Granted, we’re talking about a very small sample size. Be that as it may, the conditional probability currently stands at 52.4%. Obviously, that’s not a great success ratio if we’re being perfectly honest. But it’s a lot better than 27%.
With Wall Street’s presupposition of a random walk, you would be crazy to jump on the 220/230 bull spread with serious money. That doesn’t mean that with my presupposition of a nonrandom walk, the probabilistic risk has been eliminated. What it does do, though, is to make the proposition more rationally palatable.
Further, I’m going to defend my presupposition of a nonrandom walk because I don’t believe a quality name like Morgan Stanley stock can suffer an extended quantitative downturn and not trigger buy-the-dip sentiments. Again, this philosophy doesn’t guarantee that MS will trigger the $230 strike. But I think it’s fair to say that the idea is more plausible.
This is Morgan Stanley that we’re talking about, not some shady blockchain miner that no one’s ever heard of. With the financial giant already proving itself, it’s not an unreasonable bet that MS stock could soon break out of its consolidation phase.
