Let’s not beat around the bush: American Airlines (NASDAQ: AAL), at least in the context of an investment opportunity, has been a clunker. Since the beginning of January, AAL stock has dropped roughly 18%. Its market value has been noticeably eroding since the first of July. Nevertheless, there may be a case that the negativity may have run its course.
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As you know, market valuations are rarely ever static, especially for popular tickers like AAL stock. American Airlines also has the benefit of persistent relevance. Yes, it’s true that the economy stinks — you don’t need me to expound on that reality. Naturally, such an environment doesn’t bode particularly well for airliners. At the same time, air travel is indispensable.
Subsequently, both bulls and bears will likely be aggressively negotiating the “true” value of American Airlines stock — that’s what happens in the market. What really doesn’t happen all that often, though, is an extreme imbalance in order flows.
Actually, while these imbalances do occur from time to time, the extremes in enthusiasm typically don’t stay permanently etched. If you watch an auto race, a car’s engine is not going to stay elevated indefinitely. At some point, the driver will shift gears; otherwise, staying in one gear will lead to inefficiencies and a potential engine failure. It’s a similar principle to what we have with American Airlines stock.
Yes, the equity right now doesn’t look great. In the last two months, AAL stock printed a total of 10 weekly candlesticks on the technical chart. Of these 10 sessions, only three of them saw net positive price action. That’s going to change the immediate perception of AAL — and it’s also going to change how the market typically responds to this specific bearish condition.
What’s really compelling is that, based on historical data, the typical response would put the 13/14 bull call spread expiring Nov. 20 into play.
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Why I Like the $14 Second-Leg Strike for AAL Stock
For the November monthly chain, the currently available second-leg strikes (i.e., the sold call of the debit spread structure) range from $13 to $17. As you might imagine, the higher-priced strikes generally offer greater reward potential but at the expense of lower probabilities of success. So, the idea is to find the highest payout possible while also targeting a strike that is realistically plausible.
Stated differently, while going for the 15/17 bull spread — which offers a gargantuan payout of over 1,718% — may sound appealing, the breakeven probability of only 11.5% does not. Honestly, you’d really only go for such a high-paying spread if the underlying volatility mechanics warranted it. Since AAL stock has a relatively unremarkable 60-month beta of 1.37, it’s highly unlikely that the $17 strike will pan out.
However, the most conservative $13 strike is really a non-starter for me. The only available such spread, the 11/13 expiring Nov. 20, offers a mere maximum payout of a little over 28%. That means you have to pay a net debit of $156 for the chance to generate a profit of $44.
It’s really a terrible trade. There’s only a 40.64% chance that American Airlines stock will trigger the $13 strike on expiration. Plugging the required parameters into an expected value calculator, we would get a negative EV of $74.72. This translates into a -47.9% expected return on capital (ROC).
On the other hand, the 13/14 bull spread features only a win probability of 22.83%. That’s significantly lower than the 40.64% odds of full profitability for the lower 11/13 spread, yet the EV is a superior $14.17 below parity. Sure, that’s still a negative ROC (at -38.3%), but the $14 strike mathematically represents a more efficient use of risk capital.
It also demonstrates a critical point: improved probability alone doesn’t necessarily make a trade better. The payout must also be taken into account.
Changing the Probability of American Airlines Stock
By looking at the math above, we can see that the payout is a core component of whether an options trade is efficient or not. In an ideal world, we could try to convince the market to give us a higher payout for the same amount of risk, much like trying to whittle down the asking price at an auto dealership.
Unfortunately, the price is determined by the collective negotiation of market participants — not just one individual. Plus, Wall Street isn’t in the business of giving out a free lunch. Almost certainly, the payout will never just arbitrarily change in your favor. So, the only variable in this matter is the probability of the underlying transaction.
Functionally speaking, payouts don’t change arbitrarily on your personal whim because they represent a derivative of the underlying share price. Since the price of AAL stock is an observed event, the payout of an underlying options trade is also an observed event.
However, probabilities are a different epistemological animal. In Wall Street, probabilities are also derivatives of the underlying share price. But this mechanism is merely a statistical byproduct. You don’t have to use the Street’s preferred mechanism for pricing and “probabilizing” options, which is Black-Scholes. You can use an entirely different framework — and my argument for American Airlines stock is that you should use a different framework.
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One of the pivotal assumptions of Black-Scholes is that the target security will undergo a random walk between now and the selected expiration date. That might be a reasonable assumption for certain securities under certain conditions, but it is by no means the most effective rule in all circumstances.
For American Airlines stock, I really can’t envision an environment where it will trade randomly until Nov. 20. Historically, whenever AAL has only managed to flash three up weeks over a 10-week rolling period (going back over the trailing five years), the average median result over the next six weeks has been a move of about 7.8%.
If so, that would yield a median terminal price target of around $13.60 on Nov. 20.
Further, using the exceedance ratio as a probabilistic mechanism, we can estimate a 44.4% chance of American Airlines stock exceeding the $14 strike on expiration. Under this condition, the EV of the 13/14 bull spread rises to $7.40, translating to an expected ROC of +20%.
Suddenly, a terribly risky trade looks more compelling. Also, with a breakeven price of $13.37, the breakeven probability rises to 61.1%.
Please keep in mind that history is not guaranteed to repeat itself. There’s always a chance of a continued negative outcome, which would render the above trade useless. However, for speculators who like to play the odds, AAL stock may be more favorable than advertised.
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