Options Corner: Lingering Fears Have Sharply Discounted Nvidia Stock Call Spreads

Nvidia Corp (NASDAQ:NVDA) may be one of the hot hands on Friday but that doesn't quite erase concerns hanging over the semiconductor juggernaut. True, the company is practically synonymous with artificial intelligence, with its graphics processors powering the underlying advanced protocols. Nevertheless, from an average share price perspective, NVDA stock hasn't made much ground since last August, raising viability concerns.

Fundamentally, Nvidia faces several challenges. Overall, fears of an AI bubble have contributed to share price erosion despite compelling arguments to the contrary. One could also make the argument that valuations are stretched relative to prior periods. Moreover, the latest geopolitical rumblings — such as the Greenland takeover proposal — along with broader questions about economic stability have contributed to risk-off jitters.

Not surprisingly, the dark clouds have had a clear impact on NVDA stock options pricing. Looking at volatility skew — a screener that identifies implied volatility (IV) or the target stock's kinetic expectations across different strike prices for the same options chain — shows put options being bid across the price spectrum for the Feb. 20 expiration date. What's significant is that the put IV readings stand above the calls for most of the prices.

Effectively, traders are prioritizing downside protection, which does suggest that there is fear impacting NVDA stock. However, that's not necessarily a bad thing for the bulls. Keep in mind that the smart money is still participating in NVDA — they're just doing it in a hedged manner. Elevated call activity above the current spot price (though below the puts) indicates that there is controlled optimism.

More importantly, because downside protection is the dominant theme right now, call options are relatively cheap. So, if you had justification for optimism, NVDA stock could be an upside opportunity.

Finding The Right Trade For NVDA Stock

Using the Black-Scholes model — which is basically Wall Street's standard template for pricing options — NVDA's expected move for the Feb. 20 expiration date is projected to be between $173.44 and $201.70. Without getting overly bogged down with the math, this range represents where prices would symmetrically fall within one standard deviation from the current spot price, while accounting for volatility and days to expiration.

Basically, what this calculation tells us is that, assuming Black-Scholes accurately reflects reality, about 68% of all outcomes on Feb. 20 should land between the aforementioned prices. You can see that we have two big challenges. First, that's a big assumption. Second, while the dispersion itself is probably accurate (since most outcomes do land within a standard deviation of spot), it doesn't really tell us anything.

Let's be real: most retail traders are on the debit side, meaning that they pay a premium for the right to speculate on a forward outcome. With such a wide dispersion, you would be paying debits across the spectrum if you wanted to cover the range. That would become prohibitively and irrationally expensive. As such, we need a way to narrow down the list of suspects and that's where the Markov property comes into play.

Under Markov, the future state of a system depends solely on the current state. In the financial market, this claim simply means that forward probabilities are influenced by prior context. As elegant as the Black-Scholes model is, its mathematical architecture has no accommodation for prior context.

Now, what is the context for NVDA stock? In the last 10 weeks since Thursday's close, NVDA stock printed six up weeks but with an overall downward slope. When this rare 6-4-D sequence flashes, the forward 10-week outcomes would be expected to range between $170 and $250, with probability density peaking between $190 and $202.

Interestingly, over the next five weeks (which roughly coincides with the Feb. 20 options chain), forward outcomes for NVDA stock should be most prominent between $190 and $205, with probability density peaking at $195.

Taking Advantage Of The Relative Discount In Nvidia Stock

With the market intelligence above, there are several ideas that bullish speculators may consider. However, the one that speaks to me the most is the 197.50/200 bull call spread expiring Feb. 20. This wager involves two simultaneous transactions on a single ticket or execution: buy the $197.50 call and sell the $200 call.

Net expenditure for the above spread would be $76. If NVDA stock rises through the second-leg strike ($200) at expiration, the maximum profit would be $174, a payout of nearly 229%. While the $200 strike is ambitious, it's not unrealistic given the expected forward distribution. Also, the breakeven price lands at $198.26, adding to the spread's probabilistic credibility.

Essentially, what we're betting on is the power of consistency. Obviously, no one knows what the future will hold. Whether you depend on Black-Scholes, Markov or any other methodology, tomorrow is always a mystery. That said, we have observed that over many trials of the 6-4-D sequence, we would expect NVDA stock to land predominantly between $190 and $205.

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