Options Corner: AI Bubble Fears Have Sharply Discounted Oracle Stock

Oracle Corp (NYSE:ORCL) isn't exactly off to a great start for the new year despite ORCL stock representing one of the hottest securities in the market today. Since the beginning of January, the enterprise software giant has found itself down about 5%. Despite some tremendous bursts of performance last year, lingering concerns regarding a bubble imploding in artificial intelligence have dampened sentiment. For the contrarians, though, such fears may represent a discounted opportunity.

Right now, the market clearly doesn't see it that way. Although Oracle had previously reported exceptional backlogs that reaffirmed its role as a key AI enabler, the wheels really began to come off around October. That was when AI bubble fears gained momentum. Essentially, the thesis was that the low-hanging fruit of the broader machine learning ecosystem has already been plucked. Moving forward, enterprises must fundamentally justify their rising expenditures.

With so much being poured into AI — along with institutional and cultural fears of prior bubbles collapsing violently — it may not be particularly surprising that many investors decided to rush for the exits. And it's not just words but the sophisticated expression of this anxiety that has clouded ORCL stock at the moment.

Right now, volatility skew — a screener that displays the implied volatility (IV) or expected kinetic movement for a particular options chain — shows IV for put options standing above their call option equivalent across large chunks of the strike price range for the Feb. 20 expiration date. This appears to indicate that traders are prioritizing downside protection.

Granted, that's not the most comforting sign for bullish investors. However, the put activity also means that on a volatility basis, calls are relatively cheap. Therefore, if you have a compelling reason to buy ORCL stock, it could be at a discount. I believe that there is just such a case.

ORCL Stock Signals for a Possible Comeback

According to the Black-Scholes model — basically Wall Street's standard mechanism for pricing options — the expected move for ORCL stock for the Feb. 20 options chain is between $166.43 and $201.45. This dispersion represents a 9.52% high-low spread relative to the current spot price.

To be sure, there's plenty of mysticism surrounding Black-Scholes. Without getting bogged down by the math, the above expected move calculation represents a symmetrical forecast of where ORCL stock may end up if prices fall within one standard deviation from the spot price (while accounting for volatility and days to expiration).

To put it simply, in 68% of cases, ORCL stock on Feb. 20 would be expected to land between roughly $166 and $202. That's not a controversial point. However, it's not exactly the most insightful for us as debit-side retail traders because we're operating under the constraint of limited resources. In other words, we can't just buy debit spreads to cover the entire dispersion because that would become prohibitively expensive.

So, what do we do? We need to narrow this dispersion from a range of possibilities to a list of probabilities. To accomplish this task, we will deploy a second-order analysis using the Markov property. Under Markov, the future state of a system depends solely on the current state. Colloquially, this claim means that forward probabilities should not be calculated independently but must take into account context.

Let's use a simple sports analogy. A 20-yard field goal attempt is an easy three points. Add the context of snow, wind and playoff pressure and the probability of putting those three points on the board may change.

Looking at Oracle stock, what is the current context? In the last 10 weeks, ORCL printed six up weeks but with an overall downward slope. I'm going to classify this structural formation as a 6-4-D sequence. The significance here is not so much about the quantitative signal itself but how the market responds to it. Per the Markov property, different quant signals should yield different market behaviors.

In this case, we would expect under 6-4-D conditions for Oracle stock to range between $170 and $205 over the next 10 weeks (using a dataset that goes back to January 2019). Over the next five weeks, the range would likely not materially change. However, what's interesting is that, from the standpoint of probability density, ORCL should form a bell-curve-like shape, with peak density projected to reach around $190.

That gives us a natural target to aim for.

Trading with the Statistical Current

Based on the market intelligence above, I find the 187.50/190 bull call spread expiring Feb. 20 tempting. Given the narrowness of the spread, it's really a wager that ORCL stock will hit $190 at expiration. If it does, the net debit paid of $120 will generate a capped profit of $130, translating to a maximum payout of over 108%. Breakeven lands at $188.70.

How we got to the $190 target comes from a process known as statistical induction. In essence, we identified a quant signal — the 6-4-D sequence in this case — and we observed how the market historically responds to it. If we took the percentage returns of the 6-4-D signal specifically and applied it on aggregate to the current spot price, we would get a median target of approximately $190.

Of course, the philosophical criticism is that there's no universal law that states a security must abide by established patterns. Things can always change. But that's also a risk that applies to any methodology. In my opinion, there's strength in numbers (and frequency). As such, I am bullish on the current weakness in ORCL stock.

The opinions and views expressed in this content are those of the individual author and do not necessarily reflect the views of Benzinga. Benzinga is not responsible for the accuracy or reliability of any information provided herein. This content is for informational purposes only and should not be misconstrued as investment advice or a recommendation to buy or sell any security. Readers are asked not to rely on the opinions or information herein, and encouraged to do their own due diligence before making investing decisions.

Photo: Shutterstock