With uncertainty representing the only sure bet these days, individual tech giants such as Super Micro Computer (NASDAQ:SMCI) have been caught in a whirlwind of a risk modeling nightmare. Essentially, any number of negative catalysts can emerge, upsetting market sentiment and boding poorly for SMCI stock and its ilk. As such, it’s no surprise that market makers — the bookies of Wall Street — have been aggressively hedging for downside risk.
While it can be tactically smart to be nimble and react to various events, market makers have an unenviable job of balancing immediate risks with longer-term probabilities. Like a race car, you don’t want to adjust the aerodynamics, camber and other handling and performance characteristics to just one side of the vehicle. Instead, you need a well-balanced ride, one that can accommodate various conditions.
Nevertheless, market makers are human — and even the smartest humans make mistakes. This can lead to an overly aggressive risk-mitigation posture on one side, leaving the other side vulnerable to an unexpectedly big payout. In certain circumstances, the posturing is of such a magnitude that it arguably makes mathematical sense to initiate a wager.
When it comes to calculating probabilities for a publicly traded enterprise, the exercise is deceptively difficult. At first glance, one might assume that it’s a simple matter of dividing the number of events you’re looking for by the total number in the dataset. So, if I wanted to find the weekly probabilities of SMCI stock, I would divide the number of positive weeks with however many weeks there are in the dataset.
Doing this exercise for the entire history of SMCI gives us a long odds ratio of 54.1% — a bullish bias. However, that doesn’t help us as much as you might think. In the context of options trading, it’s not just about the movement of the security above or below the zero line. Rather, it’s about the magnitude of the movement.
To be sure, one could use average returns over any given time period to determine the magnitude component but this methodology cannot precisely tell us the odds of where the target security may end up. In large part, this is because you cannot mix the two dimensions of frequency and magnitude.
Now, to truly develop an accurate and powerful risk-modeling system, one would need to account for direction, magnitude, volatility, skew, kurtosis, mean reversion, event risk, implied volatility shifts and a host of other factors.
Or, you can do the smart thing and remove the parallax error.
In optical systems, parallax refers to distortion. When a shooter is aiming at a target from an angle, a poor parallax adjustment can throw the shot off due to the underlying visual distortion. In finance, a trader can remove this parallax error by focusing on transactions that effectively ignore the magnitude problem altogether.
One such transaction for SMCI stock is the 31.00/32.50 bull call spread for the options chain expiring April 25. This strategy involves buying the $31 call and simultaneously selling the $32.50 call, resulting in a net debit (net cash outlay) of $107. Should SMCI reach the short strike price of $32.50 at expiration, the maximum reward is $43, a payout of over 40%.
Here’s the deal: SMCI stock is already at $33.12, above where it needs to be.
In other words, the probability no longer involves attempting to calculate the direction, magnitude and timeframe of SMCI stock as a holistic agent — that’s extremely difficult. Instead, you’re making the equation two dimensional by focusing on direction and time; in other words, rise over run.
Using information provided by Barchart, the probability of profit for the above 31/32.50 bull call spread is listed as 58%. In other words, 58% of the time, SMCI stock is expected to rise above the breakeven threshold for this transaction.
However, the gap between the current market price and the short strike price of $32.50 is 1.9%. Because this trade essentially features risk inversion where the stock can fall to its target rather than rise, the probability that SMCI stock will perform better than a 1.9% loss over the next two weeks (to the April 25 expiration date) is actually 65.5%.
And keep in mind that in 65.5% of the time, SMCI stock is expected to fully generate the maximum reward. If it were simply a matter of breaking even, the actual odds of success would be 70.3%. Therefore, one could make the argument that SMCI stock is mispriced by 12.3%.
That’s a real edge that shouldn’t be ignored.
