The logo for JD displayed on an office building by Sundry Photography via Adobe Stock
For all the talk about Chinese tech firms’ massive rise to prominence, JD.com (JD) has looked rather pedestrian this year. Since the beginning of January, JD stock has slipped to about a loss of 8%. This underperformance has forced the Barchart Technical Opinion indicator to rate the equity as a 40% Sell.
Not only that, JD stock happens to be one of the worst-performing securities in the trailing month among large-capitalization companies. During this period, the ticker has slipped nearly 8%, causing grief to long-side options traders and forcing analysts to reassess the forward risk-reward profile of the e-commerce giant.
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Still, for those just entering the discussion, JD stock may present a high-risk, high-reward opportunity. Perhaps even better, the overall chaos surrounding the ticker’s value discovery process may have swung the underlying options pricing mechanism favorably for retail traders.
Volatility Skew Reveals an Interesting Dynamic for JD Stock
One factor to consider when looking at a long-side options trade for JD.com stock is the volatility skew, specifically for the Nov. 20 (monthly) expiration date. Generally, it’s a better idea to consider standard monthly expirations as they offer a broader strike ladder than weekly options. That may matter more to retail traders because of the enhanced flexibility in elements such as risk/reward profiles and debit/credit-spread widths.
Plus, the October monthly is only three weeks away — and given the choppiness of JD.com stock, I’m not entirely convinced that three weeks to expiration represents adequate time for a bullish idea to come to fruition.
Administrative points aside, there’s another reason to look at the November chain: it appears that the smart money is also interested in this particular time frame. Given the way that the volatility skew is structured, there appears to be unusually heavy premium on upside participation — specifically, that out-the-money (OTM) calls are substantially more expensive on a volatility basis than comparable OTM puts on the downside.
Translation? Tail-risk concerns exist regarding downward volatility but the options market still features unusual premiums paid for upside speculations. In other words, the counterparty — call sellers — are demanding more compensation for assuming the upside risk.
While there’s no epistemologically objective interpretation of the options market, we can reasonably infer that JD stock call sellers are iffy about accepting the underlying assignment risk. On the debit side, that could spell an opportunity.
A Nonrandom Walk Could Be Upon Us
The other factor that makes JD.com stock a must-watch name — despite its terrible performance recently — is the strike selection available for the November monthly chain. I’m looking at the 27/30 bull call spread expiring Nov. 20.
Mechanically, for a net debit (cash outlay) of $115, you would be speculating that JD stock has enough juice to trigger the $30 second-leg strike price on expiration. If it does, the maximum profit would clock in at $185, a payout of nearly 161%. That’s beautifully asymmetric in your favor — risk $115 for a chance to get $185.
Of course, the challenge centers on the probability of success. Right now, the probability of breaking even (at $28.15 on Nov. 20) is listed at 34.9%. If you play around with the numbers of the Expected Move calculator, the odds of triggering the $30 strike sit at only 19.42%.
Under ordinary math, this trade will have negative expected value. Your number of losses will simply outpace the number of wins, thus sinking your portfolio.
However, the premise that has gone into calculating these probabilities may need an adjustment because they embed a random walk modeling structure. I’m not sure if a random walk will actually materialize because JD stock is acutely bearish right now.
At the same time, the smart money — as I demonstrated earlier — is pensive about underwriting the potential upside risk in JD stock, thus demanding more premium from debit buyers. If there wasn’t this underwriting pensiveness, then I would presume they would be willing to accept a premium in line with standard random walk assumptions.
But because the call sellers are the ones carrying the legal obligation of risk assignment, I believe their sentiment is more reflective of the true market reality. And that reality may be that a nonrandom walk may occur.
The Future Depends on the Past
It’s a common assumption that you cannot predict near-term market movements and I generally think that’s true. If you asked at any random moment where JD stock is likely to head next, your guess would be as good as mine.
But I also theorize that under certain acute circumstances, you can engage in inductive reasoning to get an idea of the range where a public security is most likely to land. And that’s because we’re not randomly guessing where the stock may head. Rather, we have some context and based on that context, certain outcomes may be more probabilistically privileged than others.
In the last 10 weeks, we know that JD stock has only managed to print two net positive weekly candlesticks. That means within the defined period, 80% of the volume was net negative. Under this behavioral state, which I call 2-8-D (two up, eight down, downward slope), we know through past data that certain outcomes are more likely than others.
To get to the point, we know that in the eighth week following the flashing of the 2-8-D sequence, the median performance is about 16.94% up. From our current vantage point, that would imply JD.com stock clearing the $30 strike on Nov. 20.
If this model happens to be accurate, we would be looking at a 53.8% probability of JD stock triggering $30 on expiration.
If so, the natural question is, why is the probability above so vastly different from what Wall Street is calculating? The answer is that I’m assuming that the future is dependent on the past. Mathematically, then, the past in this case tends to historically skew the probability higher for the debit-side bull.
Food for Thought
Of course, a model of the unknown future will always be an educated guess. Therefore, I will not take offense if someone said that this particular framework is junk. Ultimately, everybody has to decide what model they find the most convincing.
In my defense, however, the volatility skew does show that call sellers do not want to assume upside risk without extra compensation relative to normal circumstances. What’s spooking them to demand such premium spikes?
This is just my opinion, of course, but I believe these pros know that the call options are mispriced in favor of the debit-side long trader. That wouldn’t be a conclusion that naturally arises if JD stock were simply expected to take a random walk.
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
