Home Depot(NYSE:HD) isn’t exactly off to a great start. Although the retailing giant represents a historically reliable investment, HD stock currently ranks among the worst blue-chip securities. In the trailing month, HD has suffered an uncharacteristic loss of more than 11%. On a year-to-date basis, the equity is down roughly 14%.
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It’s not too difficult to understand the problems ailing Home Depot stock. Overall, the economy hasn’t fully aligned with the underlying company’s business interests, with uncertainty in the real estate market taking a heavy toll. As well, do-it-yourself demand has been a bit weaker than expected, contributing to mixed financial performances for sector players.
Still, HD stock remains a relevant name despite the headwinds. There’s also a fundamental case to be made that, even under a recession, much of Home Depot’s business demand profile is durable. For example, pipes don’t decide to burst based on economic indicators; some might say that, due to Murphy’s law, they’re more likely to malfunction precisely when you don’t want them to.
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While the media understandably is focused on the percentage-wise losses of Home Depot stock, the more interesting phenomenon is the quantitative domain. In the last 10 weekly candlesticks, HD has printed only two positive sessions, contributing to an overall downward slope.
Why is this 2-8-D sequence important? First, we have the mathematical significance. Within the aforementioned time period, the bulls were only able to muster 20% net positive sessions. With the remaining 80% of the volume subjected to net bearish pressure, that’s likely a lot of weak hands that have been flushed out of the system.,
Second, and more importantly, I believe that such a pessimistic order flow imbalance is likely to alter the forward trajectory of HD stock (as compared to a more balanced profile). Essentially, from the first point, the perception of Home Depot has changed. The ticker is no longer viewed as always reliable but is currently stuck in a deeply bearish state.
Now, the question is, what is the likelihood of transition to another, perhaps bullish state? Here, the data provides an inductively encouraging perspective.
We know that since January 2009, the 2-8-D sequence has only flashed 13 times on a rolling basis — yes, just 13 in nearly two decades. Tabulating this quant state and its forward 10-week response, we may create a composite picture of what to expect next. Basically, we’re looking at choppiness over the first five weeks, then a potential upswing in the following five weeks.
If this trend turns out as forecasted over this coming future, then the 305/315 bull call spread expiring Nov. 20 may be in play.
Auditing the Probabilities of the Home Depot Stock Options Spread
For the 305/315 bull spread to be fully profitable, HD stock needs to trigger the $315 second-leg strike price on expiration. Doing so would convert the $460 net debit (cash outlay) into a $540 maximum (capped) profit, a payout of over 117%. That sounds attractive on paper but there’s a catch — and this has to do with the likelihood of actually being successful.
Wall Street’s options pricing mechanism — which basically stems from the Black-Scholes family of calculations — assigns a probability of breakeven (at $309.60) of only 35.9%. Worse yet, OptionCharts’ Probability Distribution screener declares that the odds of Home Depot stock hitting $315 on Nov. 20 is only 31.08%.
Either way you look at it, an expected value calculation will lead to poor projected results for the debit call spread, simply because the number of losses will quickly outpace the number of wins. As such, most (if not all) financial experts will steer you away from this options strategy.
However, it’s always a good idea to audit the probabilities of any forward-looking model. After all, when you’re estimating what could happen in the unknown future, no one can appeal to an absolutely neutral epistemological ground. Someone always has to make a presupposition to move the argument along.
With Black-Scholes, the core presupposition is that HD stock will undergo a random walk between now and the expiration date, with the current implied volatility (IV) — which stems from actual orders — serving as a constant across the risk-neutral journey. But we don’t know if indeed equities operate under a pure random framework. Plus, IV can easily change day by day, even down to second by second, depending on the overall circumstances.
Subsequently, I believe that a more defensible case rests on the nonrandom walk.
Because Home Depot stock suffered a historically severe downturn (at least from a quantitative angle), it makes sense that this fact alone will likely alter HD’s trajectory relative to a baseline aggregate expectation. And that’s exactly what the data shows.
Of the 13 times that the 2-8-D sequence has materialized, HD stock has hit the equivalent of the $315 strike price a total of nine times or 69.2% on week 9, which corresponds with the Nov. 20 expiration date. As for the breakeven price of $309.60, HD has exceeded this threshold 10 times or 76.9%.
Granted, we’re talking about extremely small sample sizes so statistical confidence cannot be issued. That’s going to be a clear weakness of this model. At the same time, the counterargument is that there’s a reason why the sample size is so small — this quant signal simply does not appear enough times to generate that confidence.
Unfortunately, a give and take exists within this circumstance. If we had a plethora of conditional data, the distribution of outcomes would begin to increasingly resemble a standard bell curve, thus weakening signal perception. But with a limited dataset, we are more likely to see a signal but an exponentially lower confidence.
Ultimately, the decision to trade comes down to personal risk tolerance. We can use a Markov simulator to identify the handful of potentially viable candidates. But it’s ultimately up to you to decide whether you want to pull the trigger.
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