Futures Options Swaps by Pavel Ignatov via Shutterstock
At first glance, pharmaceutical giant Eli Lilly (LLY) may seem like an awfully risky wager. On Friday, LLY stock fell 2.47%, bringing its year-to-date performance to only 0.45% above parity. For context, the benchmark S&P 500 index — which isn’t exactly lighting up the scoreboard — has gained nearly 5% during the same period. As such, the soft return looks rather conspicuous.
Further, LLY stock represented one of the entries in Barchart’s screener for unusual stock options volume — but not necessarily for good reasons. Following Friday’s closing bell, total options volume reached 54,014 contracts, representing a 29.74% lift over the trailing one-month average. Breaking down the details, call volume was 29,060 contracts while put volume stood at 24,954.
The above pairing yielded a put/call ratio of 0.86, which might seem bullish. However, options flow — which focuses exclusively on big block transactions likely placed by institutional investors — revealed that net trade sentiment heading into last weekend was more than $1.6 million below parity, thus favoring the bears. Overall, gross bearish sentiment was $3.409 million below parity while gross bullish sentiment was $1.806 million.
Still, it’s important to point out that unusual options activity — as useful as it may be — isn’t the end-all, be-all to determine the forward trajectory of LLY stock. Indeed, it would be a presuppositional fallacy to take the aberrant data from the derivatives market and assign a probabilistic thesis.
Instead, we can turn to market demand profiles to better gauge the current sentiment regime and conduct a statistical analysis on what we can expect in the future. However, to do this exercise requires some rearrangement of market data.
Initially, the process of calculating the forward probability of LLY stock (or any security) seems like a straightforward exercise: merely take the frequency of the desired outcome divided by the total number of events in the dataset. However, this exercise only calculates the derivative probability or the outcome odds over the dataset’s entire distribution.
What we’re looking for? We need conditional odds, which are the outcome odds over a specific subset of the data. To use a baseball analogy, derivative probabilities are similar to a player’s batting average last season. Conditional probabilities are akin to situational batting averages, such as when there are runners in scoring position (RISP). The latter is a much more useful metric.
Unfortunately, you can’t just plug in typical financial metrics such as share price or valuation ratios as these figures are continuous. That’s why I prefer converting stock price data into market breadth or sequences of accumulative and distributive sessions. Market breadth is functionally binary and by logical deduction is a discrete event.
In the past two months, the price action of LLY stock can be converted as a “6-4-D” sequence: six up weeks, four down weeks, with a negative trajectory across the 10-week period. Admittedly, this conversion process compresses LLY’s magnitude dynamism into a simple binary code. But the benefit is that this code can be categorized into distinct, discrete demand profiles over 10-week intervals. These profiles can then serve as the basis for past analogs to ultimately extract forward probabilities.
Specifically, when the 6-4-D sequence flashes, the price action in the following week (which in this case corresponds with the business week beginning June 30) sees upside 68.42% of the time, with a median return of 2.47%. Should the bulls maintain control of the market over the next three weeks, LLY stock could reach near $812.
With the market intelligence above, aggressive speculators may consider the 795/805 bull call spread expiring July 25. This transaction involves buying the $795 call and simultaneously selling the $805 call, for a net debit paid of $555, the most that can be lost in the trade.
Should LLY stock rise through the short strike price ($805) at expiration, the maximum reward is $445, or a payout of over 80%. Granted, based on the above numbers, one could theoretically opt for the 795/810 bull spread, also expiring July 25. However, the net debit required is $690, which is a hefty nominal risk, though the payout is enticing at 117.39%.
Either way, what makes the above strategies attractive is the implied shift in sentiment regime of the 6-4-D sequence. As a baseline, LLY stock enjoys a strong upward bias, with the chance that a long position will be profitable on any given week clocking in at 60.18%. What the 6-4-D does is to tilt the odds even more in favor of the bullish speculator.
You’re not going to get that kind of detail or insight from just reading and interpreting unusual options activity. That’s why I believe it’s important to think in discrete terms rather than attempting to find patterns in continuous signals.
On the date of publication, Josh Enomoto did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com
