From a fundamental perspective, I can appreciate the optimistic case for cruise ship operator Carnival (NYSE:CCL). On Tuesday, CCL stock represented one of the most actively traded securities, according to Yahoo Finance. Trading volume on the day reached 32.794 million shares, noticeably higher than the three-month average of 26.695 million shares. Nevertheless, when looking at CCL quantitatively, there are reasons to be concerned.
In the trailing two months, the price action of CCL stock can be converted into a market breadth format as an “8-2-U” sequence: eight up weeks, two down weeks, with a positive trajectory across the 10-week period. Admittedly, the conversion of price action into a simple binary code may seem strange, if not outright stupid. However, there’s a method to the madness.
When professional blackjack players approach the gaming table, they do so with a card-counting strategy in mind. Essentially, pro players keep a running total of the cards that have been dealt, separating individual cards into three categories: positive value, neutral value, negative value.
Fundamentally, the idea is to bet large when the odds favor the player and bet small when the odds favor the dealer. However, knowing when to strike requires the calculation of two types of probabilities: derivative and conditional. In the former case, players understand the baseline chance of success, which calculates odds across all hands. In the latter, players calculate odds for the current hand.
While the same principle can be applied to the stock market, it’s difficult (if not impossible) to calculate conditional probabilities of continuous scalar signals like stock prices. By converting the chaos of price action into discrete events, the trader can categorize and quantify demand profiles for the ultimate purpose of extracting forward probabilities.
As stated earlier, CCL stock in the trailing two months printed an 8-2-U sequence. The significance here is that since January 2019, this pattern has only materialized seven times. In five cases, the price action for the following week (which corresponds to the business week beginning July 7) results in downside, with a median loss of 8.53%.
Granted, a sample size of seven is extremely small. However, upside has only occurred twice following this pattern and the median return is a relatively paltry 2.71%. In my view, there’s a greater risk of CCL stock sharply correcting. And while I believe that the underlying company can quickly get back on its feet, the immediate numbers don’t look pleasant.
Here’s the deal: even if we were to assume a 4% loss, that would drag CCL stock down to $27.49. For those who want to play the short game, Carnival could be quite enticing.
Take a look at the options chain expiring July 25. For the 28.50/27.50 bear put spread, market makers are offering a payout of roughly 133%.
The above transaction involves buying the $28.50 put and simultaneously selling the $27.50 put, for a net debit paid of $43 (the most that can be lost in the trade). Should CCL stock drop through the short strike price ($27.50), the maximum reward clocks in at $57.
To reiterate, this is a near-term opportunity and I don’t anticipate CCL stock to be deflated indefinitely if it does correct. But for those who want to play the numbers game, the above is a tempting idea.
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