It’s not so much that Levi Strauss (NYSE: LEVI) has been a terrible investment idea. Sure, on a year-to-date basis, LEVI stock has its head slightly below parity, which is never ideal. However, given its direct ties to the consumer economy, the apparel giant could have suffered even worse losses. Further, sentiment may be coming back strong, with the equity up over 5% in the trailing month.
Naturally, this all raises the question: is LEVI stock enjoying a one-off fluke? Or does it really have the momentum to make things interesting for debit-side options traders? I believe it’s more of the latter case.
Yes, there is an argument that LEVI stock may have burned too brightly. In the last five sessions, the ticker jumped over 10%, which is a strong performance for any security. But for Levi Strauss, lingering questions about the consumer market may make some speculators hesitant — they may prefer to wait for confirmation, as technical analysts often say.
Nevertheless, a nagging criticism awaits the confirmation-seekers: once that (bullish) confirmation arrives, Wall Street will simply rerate the new risk-reward profile of the equity in question. In other words, the confirming event will almost destroy the speculative opportunity you see right now — before the confirmation of Levi Strauss stock.
Obviously, nobody can fully guarantee whether a big move will materialize or not. However, if we had some inductive inference to believe in an undervalued opportunity, we could potentially buy LEVI stock with greater confidence (rather than sit on the sidelines waiting for confirmation).
I believe such an early warning signal has already materialized. In the last 10 weekly candlesticks that Levi Strauss stock printed, only two of these sessions resulted in net positive price action. Typically, when this extremely bearish state flashes in the chart, LEVI tends to march higher, potentially placing the $22 price target for the November monthly options chain as a reasonable objective.
Why the $22 Target for LEVI Stock is Reasonable
Fundamentally, my near-term optimism for Levi Strauss stock centers on the concept of mean reversion. Basically, the theory is that publicly traded securities of stable, relevant enterprises may attempt to find an equilibrium following a sharp corrective period. However, in some cases, the target security may overshoot before settling into the baseline.
I don’t think it’s controversial at all to believe in this approach; it’s probably one of the most common technical principles. However, it’s worthwhile attempting to quantify the methodology rather than simply betting on red-stained securities.
With LEVI stock, we know that it’s not merely structured in a garden-variety bearish state. Rather, as I stated earlier, only two of the last 10 weekly candlesticks resulted in net positive action, with the overall trend across the 10-week period being negative. This particular bearish state has only materialized 12 times on a rolling basis in the past five years — thus, we know that this is a rare occurrence.
But the important point here isn’t that the market currently considers Levi Strauss stock bearish — everybody knows it. The question is, what typically happens next? Does LEVI’s bearish state continue to stay bearish? Or, as I suspect through mean-reversion theory, does it transition from its current bearish state to a future bullish one?
Thanks to historical data, we can create a program to apply an exceedance ratio at the equivalent of the $22 strike for the Nov. 20 monthly options expiration date. Under the framework of a transition from a bearish state to a bullish one, we can expect an exceedance ratio of 50%; that is, of the 12 times that the aforementioned bearish state has materialized, Levi Strauss stock happened to exceed the $22 strike on expiration six times.
Of course, there will always be variations in the market. If I had to guess a probabilistic range, it would be somewhere between 33.3% and 50%. That makes the 21/22 bull call spread expiring Nov. 20 an intriguing idea.
A Low-Cost Trade That Tempts Speculators
One aspect that stands out for the 21/22 bull spread is the low nominal cost. At $45 per spread, speculators will be betting that Levi Strauss stock rises through and triggers the $22 second-leg strike price on expiration. If it does, the maximum profit would be $55, translating to a payout of over 122%.
The other plus is the favorable asymmetry. Because the payout is over 100%, you would be profiting more than you would be betting, assuming that the trade pans out perfectly. Of course, we don’t live in a perfect world but under risk-management principles, you should aim to maximize your payout rather than to seek high probabilities in lieu of a high payout.
That said, the expected value of the $22 spread leads to sharply negative expectancy at $20.04 below zero or an expected return on capital (ROC) of -44.53%. Primarily, the reason is that the probability of LEVI stock hitting $22 on expiration is only 24.96% — a calculation derived from OptionCharts.io’s Probability Distribution screener.
Because Wall Street isn’t about to give us more payout without us accepting more risk, we would need a probability bump to make this trade worthwhile. But that was the whole exercise that we recently conducted — the market assigns a probability of 25%; we think it may be as high as 50%.
Who has the correct answer?
Leveraging the Philosophy of Probabilistic Systems
Honestly, since we’re dealing with the unknown future, nobody knows what “correct” absolutely means until the event in question eventually falsifies the underlying claim. Until then, everybody is forecasting a price from a presuppositional framework.
My presupposition is that, under certain acute circumstances, public securities will likely exhibit nonrandom trading behavior. On the flip side, the probabilities that the Street is using presuppose a random walk model. Now, I’m sure that high-level traders themselves don’t believe in the random walk exclusively. But it can’t be helped that standard options pricing mechanisms imply random markets.
So yes, if you wholeheartedly believe that LEVI stock will undergo a random walk between now and the Nov. 20 expiration date, the lower probabilities would make more sense. However, if you believe in state-to-state transitions, the data points to LEVI being a bullishly biased name.
