If you’re into safe, relatively predictable options trades, you’re going to want to turn away from Southwest Airlines (NYSE: LUV) right now. LUV stock is strictly for the most aggressive of contrarians. However, if you do live life on the edge, this deflated travel specialist just might be what you’re looking for.
Let’s be clear about the upfront risk of Southwest stock. In the trailing month, LUV has lost more than 10%. That’s not a usual circumstance judging by its 60-month beta of 1.14. Yes, it’s more volatile than the benchmark S&P 500 but not by much. Ultimately, the recent downturn has brought the ticker’s year-to-date performance to a loss of 1.5%.
Fundamentally, if you were looking for a reprieve, you would be disappointed. Google Finance’s summary sheet notes that persistent cost pressures have contributed to the underperformance of LUV stock. What’s worse, “[a]nalysts project a cautious near-term outlook for the upcoming quarter despite strong underlying domestic demand, as the market balances structural business updates against elevated operational expenses.”
Why discuss LUV stock then? For the simple reason of mean reversion.
As I noted above, Southwest stock has been swimming in red ink recently and there doesn’t seem to be a narrative on the horizon to justify an optimistic view. Nevertheless, we can reasonably assume that, despite the obvious economic challenges, there will likely be strong overall demand for low-cost air travel.
Yeah, people complain bitterly about air travel these days and they’re not wrong to issue their laments. At the same time, flying the friendly skies is far more efficient than other means of transportation, especially when time and convenience are big considerations. So, I think it’s reasonable to believe that the current quantitative structure of LUV stock — having only printed two up weeks over the last 10 weeks — will likely lead to discount bidding.
Taking Issue with the Random Walk Thesis of LUV Stock
When it comes to options trading, you can’t just wax poetic about potential upside. Instead, you have to disclose a specific price target and an expiration date. In other words, if you’re making a stance based on a particular model, the derivatives market doesn’t allow you to straddle the fence. Your proposed idea must be falsifiable — and that’s where the challenge lies.
In my personal estimation, I believe the potential upside for Southwest stock makes the 42.50/45 bull call spread expiring Oct. 16 an interesting bit of speculation. On paper, the proposal is arguably enticing. For a net debit of $94, traders are hoping that LUV rises through the $45 second-leg strike price at expiration. If it does, the maximum profit will be $156, a payout of nearly 166%.
Of course, there’s a massive catch: Wall Street defines the probability of profit (breakeven) at 32.6%. That’s quite a modest chance that LUV stock will hit $43.44 at expiration. Worse yet, when you look at the probability distribution screener, the odds that LUV will hit $45 on Oct. 16 are only about 23.4%.
Effectively, from an expected value (EV) point-of-view, you’d be throwing money at a sinking ship. If you’re only winning full profitability at 23.4% — and only breaking even at a rate of under 33% — you would simply be bleeding cash over the theoretical long run. You don’t need to be a finance genius to understand that this is a proposition to walk away from.
However, the future is unknown and by logical deduction, any forecast of the future is presuppositional. It’s like when theologians from opposing religions debate each other. Each expert may have personal conviction about what they perceive the truth to be, yet there’s no objective ground to determine said truth.
It’s the same concept in the equities market. In this case, Wall Street is pricing Southwest stock options under the presupposition that LUV will undergo a random walk between now and the expiration date, with the initial implied volatility representing the constant “fuel” throughout the journey.
I have difficulty in accepting this premise because I believe — given the sharply negative performance of LUV stock — the upcoming journey will be nonrandom.
A Nonrandom Walk is Arguably the More Plausible Scenario
As I mentioned above, Southwest stock printed only two weekly candlesticks in the last 10 weekly sessions, leading to an overall downward slope across the period. This 2-8-D quantitative sequence is not special in and of itself. It’s just a present-day observation.
But as you know, the market primarily doesn’t price securities on what is happening today (or what happened yesterday). Instead, it’s about the anticipation of future potential. That’s why public securities can trade against their fundamentals. While the present financials may imply a certain share price, the market is looking ahead to the potential future valuation.
Right now, the implication is that forward-looking circumstances are poor; hence, the red ink in LUV stock. Still, if circumstances start to improve, if fundamental sentiment rises, it’s plausible that Southwest shares could rise. If so, it would be preferable to consider acquiring exposure now, right when it appears that the weak hands have left LUV.
What makes this nonrandom proposition compelling is that we’ve seen this pattern before. Since January 2019, the 2-8-D signal has flashed a total of 17 times. Of this tally, LUV stock has risen above the equivalent of the $43.44 breakeven price a total of eight times following the eighth week of the signal flashing.
Granted, we’re talking about a very small sample size. Also, the profitability rate would come out to 47.1%, which still makes the 42.50/45 bull spread probabilistically risky. However, I would propose that 47% is a much bigger ratio than 33%.
Stated simply, I’m not saying that Southwest Airlines stock transitioned from a risky trade to a reasonable one thanks to a switch in presuppositions. I am saying that the risk posture may be less than what Wall Street is implying with its option pricing.
The Dangers of Inductive Reasoning
As a non-determinative system, I cannot by definition determine what price LUV stock will land at on Oct. 16. I’d probably break the entire financial system if I had that kind of prophetic abilities.
Instead, I’m relying on inductive reasoning, which is error-prone. Essentially, I’m noticing a pattern with Southwest Airlines stock, that extreme bearishness typically results in an above-average performance swing. But there’s no guarantee that this upswing will even materialize.
Ultimately, it’s going to come down to your personal risk tolerance. There does seem to be an exploitable pattern in LUV stock, which its extreme bearishness has triggered per my watchdog algorithm. If you want to take a bold risk, the above call spread could be enticing.
