It’s safe to say that Norwegian Cruise Line (NYSE: NCLH) isn’t exactly making investors happy this year. Since the January opener, NCLH stock has fallen 21%. Recently, over the trailing month, the ticker has managed to lose roughly 10% of market value. Yet if history is any guide, the pessimism could represent a contrarian opportunity.
To be fair, the fundamentals don’t seem particularly supportive of a bullish posture for Norwegian stock. According to Google Finance’s summary sheet, NCLH’s “downward movement was primarily driven by management lowering full-year guidance alongside high energy costs and a prominent broker downgrade. For the upcoming quarter, analysts project a challenging period as sentiment suggests ongoing yield compression and elevated net leverage will continue to pressure the equity.”
At face value, that write-up doesn’t sound compelling for the bulls — and to be honest, I’m not sure what the long-term picture holds for NCLH stock. But if we were looking at the ticker from a near-term outlook, it’s difficult to not be at least somewhat intrigued with the bullish proposition.
As an overview, I’m referring to the concept of mean reversion. I don’t think it’s terribly controversial to say that Norwegian is overall a solid enterprise in a very relevant industry. Sure, the current economic circumstances impose challenges for the broader discretionary consumer space. But outside this specific timeline, it’s reasonable to be optimistic about Norwegian and the cruise line industry, if only because the underlying product offers significant bang for the buck.
Therefore, I would say it’s also not unreasonable to believe that anytime NCLH stock suffers an extended downturn, a non-zero probability exists that major market participants may view the red ink as a buy-the-dip opportunity. That’s my argument in a nutshell.
When Norwegian stock suffers a long series of negative sessions, the historical response has been for the market to bid shares up. If the same trend happens again over the next few weeks, the cruise ship brand could lead to possible profit scalping.
NCLH Stock Suffers from Very Low Odds (But That’s a Presupposition)
Let’s get down into the hard details. In the last 10 weeks, Norwegian Cruise Line stock has only managed to print three up weeks, leading to an overall downward slope from the opening price of the period to the close. Under this 3-7-D quantitative sequence, NCLH as a median endpoint is expected to rise about 7.7% at the end of the fifth week since the flashing of the aforementioned signal.
If this observed pattern materializes again over the next five weeks (keep in mind that I’m writing this on the evening of Aug. 18), NCLH stock could just about hit the $19 price point on Sep. 18. Based on this empirical data, I would assume that the 18/19 bull call spread expiring on that date would be an attractive trade.
Under this transaction, NCLH stock would need to rise through the second-leg strike at expiration. If so, the $42 net debit paid to enter the trade will turn into a maximum profit of $58 or a max payout of 138.1%. From a nominal-cost-to-potential-reward perspective, the 18/19 call spread seems enticing. However, there’s a major problem — two problems actually.
First, the breakeven price for the above spread is $18.42 but the probability of reaching this threshold is only 36%. Second, the probability distribution screener defines the odds of Norwegian Cruise Line stock hitting $19 at expiration at only 27.48%.
You don’t need to be a math genius to see that under this framework, the spread would likely generate negative expected value (EV). Over the theoretical long run, you would be losing money far more than you would win it. That’s not a recipe for success.
However, the biggest detail you must keep in mind is that these probabilities are inferred based on Wall Street’s presupposition. Specifically, the odds stem from the Black-Scholes family of calculations, which assumes that NCLH stock will undergo a random walk from the current starting point to the expiration date.
Yet it’s this very presupposition that I would like to challenge.
Order Flow Imbalances Typically Lead to Nonrandom Behavior for Norwegian Stock
Personally, I don’t think it’s appropriate to price NCLH stock assuming a random walk for these upcoming weeks. That’s because we quantitatively know that Norwegian has suffered a sharply negative order flow balance (3 up weeks, 7 down weeks, downward slope). In fact, the data shows that such quantitative pessimism typically leads to an outsized move.
Forget the financial lexicon for a moment. I approach the equities market like a pharmaceutical company testing the efficacy of its drug. In the case of Norwegian stock, we have a test group, which is data filtered under the 3-7-D signal. We’re then comparing it to the control group, which is the raw, unconditioned baseline.
So, if there is something special about the test group data, it should perform noticeably differently from the baseline. And that’s exactly what the data suggests. As I said earlier, on week 5, we would expect NCLH stock to shoot up about 7.7%. Under baseline conditions, the ticker should barely rise from the current spot price.
Now, if you want to drill into the matter, consider this: going back to Norwegian’s IPO, NCLH stock has flashed the 3-7-D signal a total of 40 times. At the end of week 5 (roughly Sep. 18), the ticker has been projected to exceed the equivalent of the $40 strike price 18 times. That comes out to a success ratio of 45%.
With the 18/19 call spread’s max payout of 138%, a standard EV calculation should theoretically net a positive gain over the long run. Also, keep in mind that between $18.96 and $19, there are an additional three “hits” based off the 3-7-D signal. As such, the 45% rate isn’t as modest as it may appear. Moreover, it’s a much better ratio than 27.48%.
Risks to Watch
To be fair about the point of presuppositions, I’m also making one. In other words, while you may find the calculations that I ran to get the higher success rate convincing, I can’t guarantee the absolute truthfulness of the probability.
Unfortunately, that’s the limit of inductive analyses. Just because a certain pattern has consistently materialized in the past does not necessarily mean that it will repeat in the future. It’s always possible that when you decide to pull the trigger, the market may do something completely unexpected.
So, am I just talking out of my rear? No, I will defend this methodology — which is built on Markov chains — because I believe the initial premise is very reasonable. When good companies suffer extended downturns, the statistical response to the downfall should be nonrandom. I’m just finding the ideas that are nonrandom enough to justify taking the risk on the debit side.
Again, that doesn’t mean that the trade is guaranteed to work. But with enough discipline over the long run, I believe this approach should yield more positive results than negative ones.
