I’m just going to get right to the point: I believe a quantitative signal is pointing to upside in fast-food giant McDonald’s (NYSE: MCD). Of course, with the Golden Arches being a blue chip, the opportunity may be best leveraged by an options trade rather than the actual equity of MCD stock. It’s not a for-sure opportunity, meaning that there’s huge probabilistic risk. But…I must say it’s awfully tempting.
Table of Contents
Listen, I’m not going to bore you with all the fundamental details. In my opinion, if you want a discussion about the earnings trends and discounted cash flows, you can peruse one of the many articles on the subject. They all pretty much say the same thing as your favorite mainstream financial publication — despite any glitz and glamour — is downstream of informational distribution.
If I’m going to take your time, you want an analysis that’s actually meaningful, something that you don’t often hear in mainstream publications. So, if you want to get down to the nitty gritty, I’m looking at the 280/285 bull call spread expiring Sep. 18. Just to quickly recap, this transaction is a capped-risk, capped-reward idea, requiring MCD stock to trigger the $285 strike at expiration to achieve full profitability.
At surface level, most folks may be deterred from the capped-risk nature of a vertical options spread. However, if you were to buy the $280 Sep. 18 call straight up, you would have to pay a current ask of $3.90. That means McDonald’s stock must reach $283.90 just to break even on the trade (based on intrinsic value).
However, if MCD stock does reach that price, the 280/285 call spread would be in the money. If the ticker closes at said price at expiration, you’re looking at a sizable profit — not just accepting a draw. Since MCD historically doesn’t move that much, a vertical spread is arguably the better strategy for debit-based traders.
Why the Risk Behind MCD Stock is Also the Potential Reward
You don’t have to accept my word for it that McDonald’s stock is a rather sleepy investment. Right now, the historic volatility for the Sep. 18 options chain is around 23%. However, the current implied volatility (IV) — or the market’s expectation of movement based on actual order volume — sits at around 20.4%.
In other words, even though MCD stock is historically a slow-moving ticker, it is expected to be even slower than usual. Now, as I write this, McDonald’s trades at $272.25 (the evening of Aug. 13). For the equity to reach $285 a pop, it would need to rise 4.68%. That doesn’t seem likely based on the current IV.
Not surprisingly, Wall Street has assigned a very low probability that the Sep. 18 280/285 bull call spread will even reach breakeven. You’re looking at rather modest odds of 30.1%. For McDonald’s stock to hit $285 at expiration, the probability of doing so is defined as only 25.12%.
OptionCharts provides an excellent breakdown of the chances your trades can be profitable through its Probability Distribution screener. But a reasonable question to ask is, how do we know that this estimate is true?
The answer: you don’t. It’s a presupposition.
Now, I don’t mean that presuppositions are bad. Indeed, many would argue that in order to have an argument, there must first be a presupposition. However, you must realize that not all presuppositions are equal. A silly example is that I can presuppose that the earth is flat. That claim alone doesn’t imbue my argument with authority.
Probability distributions should also be met with the same level of skepticism. Yes, the chances of MCD stock reaching $285 at expiration being 25.12% are valid if you presuppose that MCD will reach its target at the specified time by taking a random walk, assuming that the initial volatility reading stays consistent throughout the random walk.
Every probabilistic reading from Black-Scholes actually presupposes two major elements: the random walk itself and that IV stays consistent. I would argue that neither argument holds water in real-world trading.
McDonald’s Stock May Take a Nonrandom Walk
In contrast to the Street’s perspective, I believe that MCD stock will take a nonrandom walk. How is it that I’m making such an argument? It’s because McDonald’s is quantitatively in a bearish cycle. As such, professional market participants may perceive MCD as a discounted opportunity. Another way to look at it is mean reversion but with a plausible narrative behind it.
Of course, mean reversion itself is a presupposition — I’m not denying that. I would simply state that it’s a more credible presupposition. Through multiple observations, we recognize that the market is reflexive. We can’t determine what an equity’s future value is because outside factors influence the security’s valuation.
Regarding McDonald’s stock, I believe it’s due for mean reversion based on its order flow imbalance. In the last 10 weeks, MCD has printed only three up weeks, leading to an overall downward slope. While this 3-7-D quant sequence has only materialized 23 times on a rolling basis since January 2019, when it has flashed in the technical charts, the subsequent 10 weeks typically sees upside.
I want to be careful here and say that the positive outcome is not guaranteed — not in the slightest. Instead, what we’re doing is called inductive analysis. We’re observing patterns tethered to a specific signal and because this signal has now appeared, we’re hoping that the historical median outcome will be the true reflection of the future.
In Wall Street’s case, it’s assuming that MCD stock will take a random walk regardless of current market conditions. At the end of the day, we’re both making guesses. But I’m trying to make my guess based on what was happened in the past under similar circumstances.
In the circumstances we’re in right now, the forward trajectory has typically been a nonrandom performance.
Putting the Data Together
I just stormed through 970 words so now I need to get to the point. Based on a Markov chain simulation of past data, MCD stock is forecasted to hit a median endpoint price of around $287 at the end of the fifth week of the signal flashing (coinciding with the Sep. 18 expiration date). That’s why I’m excited about the 280/285 bull spread.
By paying a net debit of $150 to enter the spread, you’re hoping that McDonald’s stock triggers the $285 strike at expiration. If so, you earn a profit of $350. Adding to the enticement, the breakeven price for this trade is $281.50.
Out of the 23 times that the 3-7-D signal has flashed, MCD stock has exceeded the equivalent of the $285 strike and the equivalent of the $281.50 breakeven price a total of 14 times and 16 times, respectively, at the end of week 5. You’re looking at conditional, observed odds of 60.9% and $69.6%.
Granted, the small sample size means that the extracted probabilities must be taken with a grain of salt. There’s a lot of risk here, let’s be straightforward about that. However, I’m going to argue that the odds that pro traders may view McDonald’s stock as a discount has been heightened. If so, that might make the $285 strike a compelling target.
You also have to figure that when running expected value calculations, you’re looking at positive EV. Under my model, since you’re winning 60.9% of the time, you would be projected to make $213.15 over the long run while losing only $58.65. Thus, the theoretical net gain — assuming you traded this exact trade multiple times — would be $154.50.
Obviously, this analysis puts me at complete odds with Wall Street’s calculations. But if you do some additional research, you might arrive at the conclusion that the 280/285 call spread is favorably underpriced.
Leave a Reply