Let’s face reality: International Business Machines (NYSE: IBM) is an ugly name in the tech sector, thanks to modest growth metrics and reduced guidance for the full fiscal year. Naturally, management has kicked its positive framing of the disaster into high gear, insisting that the company still has the appropriate strategy toward artificial intelligence. Unfortunately, that hasn’t really helped the case for IBM stock.
Over the trailing month, the legacy ticker has dropped more than 21%. As of this writing, the year-to-date performance of IBM stock is over 30% below parity. After suffering one of the worst single-day drops in corporate history, many investors are understandably skeptical about “Big Blue” — especially because the downfall has implications for the broader tech ecosystem.
Further, some traders may have adopted a wait-and-see approach, which anybody can respect. But the problem with this methodology is that, should IBM stock enjoy a contrarian swing higher, those sitting on the fence will likely miss out on the bulk of profits.
Now, you don’t need me to wax poetic about the tech juggernaut. There are so many opinions out there and mine would be just another drop in the bucket. What’s really interesting, though, is the smart money. When you look at how options traders are positioning their exposure to IBM stock, a clearer picture of professional contrarianism begins to emerge.
Specifically, I’d like you to consider the volatility skew of the options chain expiring Sep. 18. Visually speaking, you’ll notice that the skew is weighted heavily toward the right side or the call side. Specifically, peak implied volatility (IV) — or the market’s expectation of future price movement — for out-the-money (OTM) calls stands at 125.64%. On the other end, peak IV for OTM puts only reaches 79.7%.
What does this mean? In simple terms, traders are prioritizing upside convexity over downside protection. Stated differently, the main risk that the smart money sees is that IBM stock could swing higher rather than fall apart. If so, debit-side traders want to make sure they have leverage for this potential upside move; hence the higher demand for OTM calls.
IBM Stock May be Statistically Signaling for a Bounce Back
Without getting deep into the mathematical weeds, I would argue that the core premise of most equity market analyses is that future market returns stem from dependent variables. In other words, the probability of the future state occurring depends on the current state.
Indeed, this concept represents one of the most assumed — and therefore unchallenged — presuppositions in the market. Instinctively, we know that if a major public security like IBM stock suffers a catastrophic decline, the future outcome will be influenced by this drop. We can also make reasonable assumptions that this future outcome will likely be different than if IBM had instead enjoyed a blistering rise.
What are we saying here? Again, it’s an easily understandable concept: the market responds to whatever has recently happened. Therefore, the future state of the market depends on its current state. This is the heart of Markov theory when applied to the equities market.
Now, even though most folks accept the above presupposition, very few in the financial ecosystem quantify the implication. And this implication is that if we know what the current state of IBM stock is, we can estimate the probability of where the ticker may end up at some future point in time based on past empirical observations.
For example, we know that in the last 10 weeks, IBM stock has only managed to print four up weeks, thus leading to a downward slope. This 4-6-D quant sequence has materialized 45 times since January 2019. Following the flashing of this signal, the forward return over the next 10 weeks typically exceeds that of a random 10-week hold.
Specifically, over the next 10 weeks, bullish traders may expect a distribution between $199 and $232 (assuming a starting price of $206.65). In contrast, a random 10-week hold would likely yield a range between $206 and $211.
Plus, it should be noted that the positive variance between the signal and the random baseline is not perfectly linear. For instance, on week 8 following the flashing of the 4-6-D signal (which coincides with the Sep. 18 expiration date), the median endpoint for IBM stock is around $222.
Just Doing the Simple Math
Because we know what we’re looking for and what to reasonably expect based on the above inductive analysis, we can approach the options market with a clear head. If IBM stock at $222 at week 8 is the median outcome, going for aggressive strikes at $230 or $240 would be divorced from established statistical reality.
As such, we may be interested in the 210/220 bull call spread expiring Sep. 18. If IBM stock rises through the second-leg strike at expiration — of which there would be historical precedent — the maximum payout would clock in at 102%.
Mathematically, what’s perhaps most compelling about this particular spread is the breakeven price of $214.95. Right now, Wall Street is assigning a probability of profit of 40.6%. When combined with the 102% max payout, this trade will likely generate a negative expectancy over the long run.
However, keep in mind that the 40.6% odds have been calculated using the Black-Scholes model, which assumes that future market returns stem from independent variables. Because the model assumes a risk-neutral, lognormal environment, it doesn’t take into account how IBM stock dropped to its current price of $206.65. Instead, the framework assumes that IBM will take a random walk from now until Sep. 18.
Respectfully, I dispute the idea that IBM stock will trade along a random walk over the next eight weeks. Instead, as I said earlier, Big Blue currently has a 4-6-D quant structure. Historically speaking, when this signal has flashed over the past several years, it has led to an above-average performance that is not likely to be explained as random chance.
If we continue to follow the logic of my model, of the 45 times that the above signal has flashed, IBM stock has jumped above the $214.95 breakeven price a total of 26 times on week 8. It’s possible, then, that the conditional and observed probability of profit is 57.8%.
Essentially, this calculation may mean that options traders are underpaying for the risk that they would historically absorb under similar conditions. Assuming you believe the validity of my model, that makes IBM stock options a discount — not because I said so but because the data points to the favorable risk distortion.
