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HomeFinanceHow to Use ‘Catastrophe Modeling’ to Finetune an Options Trade for Toast...
How to Use ‘Catastrophe Modeling’ to Finetune an Options Trade for Toast Inc (TOST)
While trading options can be an incredibly lucrative exercise thanks to the underlying leverage, the practice is also wildly risky. With open-market securities, the most common risk is suffering a decline in paper value. On the other end, a paper loss in derivatives may wipe out your entire principal — or much, much worse for unhinged exotic strategies.
Given the dangers, it’s prudent to apply frameworks from risk-management disciplines, particularly the insurance industry. One popular and powerful methodology is known as catastrophe modeling or cat modeling for short. Essentially, this approach simulates natural disasters and develops exceedance probability (EP) curves — distributions that measure whether losses will be equal to or greater than a specified amount over a given time horizon.
It’s just that rather than looking at hurricanes, we can measure unusual variances in equities.
Let’s consider Toast Inc (TOST) as an example. While TOST stock has been a strong player over the past 52 weeks — gaining nearly 41% — it has encountered a bout of weakness recently. For example, in the trailing month, TOST is down roughly 12%. Right now, the Barchart Technical Opinion indicator rates shares as a 24% Weak Sell.
On Monday, TOST stock was one of the biggest losers, shedding more than 5% of equity value. Unsurprisingly, TOST made the ranks of Barchart’s Unusual Stock Options Volume list but for undesirable reasons. On the surface, circumstances seemed favorable, with 65,789 contracts exchanging hands, representing a 191.41% lift against the trailing one-month average. Also, 45,657 contracts were allocated to call options.
However, options flow — which focuses exclusively on big block transactions — revealed that net trade sentiment slipped to $727,800 below parity, thus conspicuously favoring the bears. With TOST stock down 21% since Aug. 1, it’s not shocking that the professional players want out.
Still, the mass exit could be an opportunity.
To be 100% clear, the idea of betting on TOST stock is speculative — perhaps on the cusp of foolishness. Multiple experts have cited the possibility of the U.S. economy slipping into stagflation, which is obviously a real concern: a weakening labor market and stubborn inflation will do that. Nevertheless, there is an empirical justification for taking a contrarian bet.
Using data from Toast’s initial public offering four years ago, we can plot out the median expectation of TOST stock over the next 10 weeks, along with the exceedance probability (based on TOST’s closing price of $38.92 on Monday):
+1 week : Median price $39.06 | 54.21% EP
+2 weeks: Median price $39.52 | 55.26% EP
+3 weeks: Median price $39.59 | 56.32% EP
+4 weeks: Median price $39.88 | 54.74% EP
+5 weeks: Median price $39.50 | 55.79% EP
+6 weeks: Median price $39.40 | 53.68% EP
+7 weeks: Median price $39.99 | 53.68% EP
+8 weeks: Median price $39.83 | 56.84% EP
+9 weeks: Median price $39.48 | 54.74% EP
+10 weeks: Median price $40.56 | 60% EP
Quantitatively, in the trailing 10 weeks, TOST stock has printed a 4-6-D sequence: four up weeks, six down weeks, with an overall downward trajectory across the period. Now, what makes TOST both risky and rewarding is that the median pathways (anchored to first-week outcomes) associated with the aforementioned sequence features projected price ranges widely discrepant from the median pathway of all outcomes.
However, in the latter weeks of the forecast, the average of the conditional pathways generally exceeds that of the all-outcomes median. Thus, it may make sense to consider a vertical spread in these weeks to advantage the favorable delta.
For instance, in week 9 — which matches the Nov. 21 options chain — the exceedance probability is about 55%, targeting a TOST stock price of $39.48. However, the average of the forecasted conditional pathways associated with the 4-6-D sequence lands at $40.29. Therefore, speculators are mathematically incentivized to take a more aggressive bet as the sequence is signaling a greater magnitude of success relative to what would normally be expected.
Using the market intelligence above, the one trade that makes the most sense may be the 38/42 bull call spread expiring Nov. 21. This transaction involves buying the $38 call and simultaneously selling the $42 call, for a net debit paid of $188 (the most that can be lost in the trade).
Should TOST stock rise through the second-leg strike price ($42) at expiration, the maximum reward would be $212, a payout of nearly 113%. Breakeven is currently at $39.88, which is below the $40.29 average of the 4-6-D sequence’s conditional pathways.
Stated differently, the logic is that the EP (relative to the $38.92 anchor) on Nov. 21 is projected to be 54.74%. Usually, when EP is positive, the forecasted price is $39.48. However, under the framework of the 4-6-D sequence, the EP should be higher (probably at least around 56%), with a forecasted price above breakeven.
If speculators are able to catch a lucky break, TOST stock has previously demonstrated more than enough firepower to hit $42. Thus, I would watch this name very closely over the next two months.
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
