If options traders’ main objective were simply to place a binary wager on Dutch Bros (NYSE: BROS) — essentially that BROS stock would rise higher against the current spot price — the trade would arguably be an incredibly straightforward one. We’re not talking about a complicated business model here. The company provides delectable, drive-thru coffee and similar pick-me-up beverages.
In a hectic world, we can all use a little caffeine boost. And because Dutch Bros enjoys a brand name that resonates with its core (and growing) customers, the idea that BROS stock will move higher isn’t far-fetched in the least. But it’s also an expected outcome, which means we shouldn’t expect to be rewarded that handsomely for an obvious idea.
Plus, the options market isn’t exactly a philanthropic enterprise. It wants to take your money. Your job, then, is to limit the number of variables to the point where you’re mathematically comfortable in taking the risk.
Let’s start with what we know. Fundamentally, Dutch Bros stock has found itself struggling, most recently due to concerns related to the underlying company’s third-quarter earnings report (released on Nov. 4). Per Google Finance’s summary sheet, while the drive-thru barista slightly beat revenue expectations, it fell short on earnings per share. Perhaps more importantly, macroeconomic headwinds dragged on customer growth, contributing to a sharp selloff post-disclosure.
Technically, much damage has been done to the charts, with BROS stock suffering a loss of 11.25% in the trailing month. On a year-to-date basis, the ticker is down nearly 45%. It goes without saying that smart money traders have clear incentives to hedge against further downside volatility.
There’s a wrinkle to this narrative, however, and that’s the theory of mean reversion. Generally, contrarians are going to look for a reversal of fortunes when sentiment is currently weighted heavily on one side. Because the business is simple and relevant, such reversion may be plausibly applied to Dutch Bros stock.
Mean Reversion Isn’t Just a Random Idea for BROS Stock
We have one more fact that we must consider before we get into the speculative lane. For Dutch Bros stock, mean reversion isn’t just a hot take: there are data points that back the theory. We know that when the tally of positive weekly candlesticks greatly outnumbers negative candlesticks over a rolling 10-week period, a tendency exists for BROS to rise higher than the random aggregate 10-week performance would suggest.
Why is that the case? It would appear that equities trading resembles Markov chain axiomatic transitions, where the probability of transition to a future state depends on the current state. In this case, BROS stock is structured in a deeply negative state, one where it has printed only three up weeks over the last 10 weeks. Statistically, the appearance of this negative state leads to an outsized performance relative to the random baseline expectation for BROS.
In terms of raw numbers, over the next 10 weeks, it’s possible that BROS stock can gradually rise toward a median endpoint price of around $40. The problem, though, is the compounded volatility. Currently, BROS commands a 60-month beta of 1.97 — twice as volatile as the benchmark S&P 500.
So yes, statistically, if we were to extrapolate how the Markov transition from bearish-to-bullish states would look mathematically, the 37/40 bull call spread expiring Jan. 15 would seem quite attractive. With only a $90 net debit at risk, you’d be anticipating that Dutch Bros stock can trigger the $40 strike on expiration. The probability would be estimated at 47.8%.
Now, we have to be super-careful here with specific ratios like 47.8%. That’s an empirical but naïve observation, which assumes that the environment in which BROS stock would be trading under is relatively static. However, if highly dynamic or variable events were to materialize over this 10-week period beyond what is historically observed for BROS, the inference could be way off.
Stated differently, the January monthly trade would reduce time-to-expiration risk but at the expense of much higher event risk.
Dutch Bros Stock Isn’t Limited to Just One Pathway
If you don’t like the idea of excessive event risk, you could go the other way; that is, you can lower the strike price target that BROS stock must exceed but trim the time to expiration. Here, I’m going to highlight the incredibly speculative (but mathematically rational) 35/37 bull call spread expiring Nov. 20.
As you might notice off the bat, it’s crazy risky. You only have two weeks until this bad boy expires. But on the positive side, the overall stats make this idea plausibly feasible. Basically, you’re betting a net debit of $75 in the hopes that Dutch Bros stock triggers the much friendlier $37 strike on expiration. If it does, you’re looking at a maximum payout of roughly 167%.
Admittedly, from an expected value (EV) perspective, you’re not looking at the most sterling trade. However, the expectancy is in positive territory: $3.20 in the black or a return on capital of +4.27%. Yes, you might be tempted to stretch the expiration date to Dec. 18. Unfortunately, with the way the options are currently priced, the December monthly forces you to take a higher event risk than what I would consider to be justified.
Of course, the obvious problem with the November monthly is that time risk may be far too high for conservative traders. But if you’re dead-set on Dutch Bros stock, there doesn’t seem to be much mathematical wiggle room.
If positive expectancy with reasonable fundamental probability is your gold standard, then it appears you have two choices: go with a short-term wager or a longer-term bet.
Concluding Analysis
Ultimately, none of the inferences made in the above analysis can be guaranteed. Indeed, the reason why these “cheap” debit spreads offer relatively robust payouts is because of the inherent uncertainty involved. That said, we do know that BROS stock enjoys a historical tendency for mean reversion, which is potentially positive news for contrarians.
However, the big unknown — beyond whether the stock will actually move higher over these next few weeks — is the size and scale of the inference. The options market forces you to make a specific wager, and if you’re off by a little bit, that could be the difference between winning and losing.
Honestly, the best we can do is to narrow down the variables. By performing this exercise, we at least have some confidence that there are likely only two mathematically rational approaches: a tight, near-term wager or a loose, long-term wager.
