Among large-capitalization companies, Royal Caribbean (NYSE: RCL) happens to be one of the worst performers over the trailing month on a percentage basis. Specifically, RCL stock has slipped 14.54% over the past 30 days (ending Sep. 18). At the same time, the cruise ship operator could be a possible candidate for a recovery trade.
Interestingly, out of the 200 worst large-cap losers on Friday, 49 of these deflated names flashed what I would call the “3-7-D sequence.” That is, in the last 10 weeks, only three of the weekly candlesticks were positive sessions, which naturally means that 70% of the defined period was dominated by net selling pressure. That’s an awfully bearish behavioral state that will likely have an impact on both the perception of RCL stock and its eventual forward trajectory.
However, I’m not presupposing that just because the 3-7-D sequence flashed, Royal Caribbean stock will move higher. That would be an example of affirming the consequent. Instead, I want to ask a deeper question. Of the 49 stocks that flashed this signal, how many of them actually saw a positive variance between the targeted outcome and the aggregate baseline performance?
Among the handful of names that actually popped to a sizable degree, RCL stock may be the most compelling. It’s not just about the statistical fact that RCL tends to move noticeably higher following the signal. Rather, the desired options strategy to potentially take advantage of the projected pricing discrepancy is asymmetrically favorable to the debit-side trader.
In other words, speculators may be able to put down a relatively limited amount of money to generate a disproportionately large profit should circumstances pan out favorably for Royal Caribbean stock. While the trade itself may be risky, the juice could be worth the squeeze.
Presenting the Statistical Framework for RCL Stock
On average, when Royal Caribbean stock had flashed the 3-7-D sequence (on a rolling basis) going back to January 2019, the average outcome of RCL ranged between $220 and $300 over the next 10 weeks. In contrast, the average outcome as an aggregate of all histories of rolling 10-week sequences is a range between $240 and $270.
Basically, while the risk tail expands under the signal, the reward tail expands that much more. Subsequently, volatility-tolerant traders are incentivized — all other things being equal — to consider taking a shot on RCL stock.
However, when we look at a week-by-week forecast, much of the bullishness is projected to materialize in the later weeks. Given that most of the strike-selection diversity is typically prevalent on monthly options chains, the ideal date to exploit a possible mispricing in RCL stock would be for the Nov. 20 expiration date. This target aligns with week 9 of the forecast.
For that time period, the median terminal expectation is approximately a 12.3% move up. If so, that would put the 260/270 bull call spread expiring Nov. 20 in possible contention. Speculators would pay a net debit (cash outlay) of $390. Should Royal Caribbean stock trigger the $270 second-leg strike price on expiration, the maximum profit would be $610, a payout of over 156%.
On paper, this risk-reward asymmetry — risk $390 for the chance to gain $610 — is quite alluring. However, the odds of RCL stock actually triggering the necessary threshold in time are very modest.
Questioning the Presupposition Baked into Royal Caribbean Stock
According to Wall Street’s options pricing mechanism, the probability of the 260/270 bull spread breaking even at a price of $263.90 (on Nov. 20) is defined at only 34.2%. Worse yet, OptionCharts’ Probability Distribution screener identifies the chance of RCL stock hitting $270 on expiration at only 28.31%.
If you ran a quick expected-value calculation, you would realize the core dilemma. If you ran this identical trade over the theoretical long run, your portfolio will quickly sink as the number of losses outpaces the number of wins. If the statistical best outcome you can hope for is to break even at around 34%, this trade would simply not be worth pursuing.
However, the avoidance of this idea would largely center on acceptance of the presupposition that undergirded the above probabilities. What people often don’t realize is that any argument about the future is necessarily presuppositional. As such, it makes sense to consider the premise that most likely aligns with market reality.
For the RCL stock example above, the probabilities were derived from the Black-Scholes family of calculations. This system presupposes that RCL will undergo a random walk between now and the selected expiration date, with the current implied volatility serving as a risk-neutral constant across the journey.
One of the mathematical consequences of this framework is that the future is independent of the past; that is, it doesn’t matter the path that RCL stock took to get to the current (time-of-writing) price of $245.81. However, most of us believe in an entirely different presupposition — that the future is dependent on the past.
Path Dependency Undergirds Transitional Probabilistic Assumptions
While I can’t empirically prove it, I believe the case of path dependency is self-evident. Think about the path that Royal Caribbean stock took to get to nearly $246. As I mentioned earlier, RCL lost 14.54% in the trailing month. That’s going to change the perception of the cruise ship operator and where it may end up, as opposed to if RCL had enjoyed a 14.54% gain.
In the latter case, there may be a risk that too much good news is baked in. With the former, it’s the opposite argument: too much bad news is baked in, which potentially increases the probability of a contrarian swing higher.
In fact, that’s what the data shows. Since January 2019, RCL stock has flashed the 3-7-D sequence a total of 25 times on a rolling basis. Of this figure, RCL has risen above the equivalent of the $270 strike price 15 times on week 9 (Nov. 20). That comes out to a hit ratio of 60%. To break even at $263.90, the probability comes out to 64%.
Granted, we are talking about small sample sizes, so that must be taken into account — we simply cannot generate true statistical confidence with this trade. However, there is reason to believe that under a path-dependent framework, the probabilities of upside for RCL stock are superior to those of a path-independent model.
Since I would make the argument that the future is likely dependent on the recent material past, it would seem that the 260/270 bull spread is conceptually mispriced.
