Options Corner: Excess Fear For Datadog Has Opened A Contrarian Trading Opportunity

Datadog Inc (NASDAQ:DDOG) provides the plumbing layer of modern software, with the expanded distribution of systems making observability mission-critical rather than discretionary. As such, companies may be able to slow their expansion in this trend but they can't outright ignore it. Subsequently, Datadog represents one of the more relevant structural components of the broader artificial intelligence narrative. Unfortunately, DDOG stock doesn't have much to show for it.

Over the past one year period, the observability specialist — which operates as a Software-as-a-Service (SaaS)-based data analytics platform — has lost about 7% of market value. Since the close of the Nov. 10 session, DDOG stock lost nearly 29%, which fell victim to broader AI bubble fears, along with concerns tied to excess spending.

Essentially, the idea is that investors believe the low-hanging fruit of AI and similar innovations has already been plucked. Now, there is greater scrutiny about how that capital is disseminated — and this skepticism is imposing a real impact on the financial arena.

Specifically, volatility skew — a screener that identifies implied volatility (IV) or a stock's potential kinetic output  — for the Feb. 20 options chain shows put IV stand above call IV across most of the strike price range. Fundamentally, this setup tells us that options traders are overwhelmingly prioritizing downside protection.

Essentially, the far out-the-money (OTM) puts provide volatility insurance while the deep in-the-money (ITM) puts basically create a synthetic short exposure, possibly to protect long positions. To be fair, the smart money being so pensive about DDOG stock isn't a great endorsement but here's the important point: the traders are still participating in Datadog through options, not selling it outright.

Also, it's worth mentioning that because downside protection is being prioritized, "naked" bullishness expressed through call options is cheap on a volatility basis. So, if you have reason to buy DDOG stock, it could be a genuine discount.

I believe the quantitative picture provides that reason.

A Second-Order Analysis Reveals A Potential Discount In DDOG Stock

According to the Black-Scholes-derived expected move calculator, DDOG stock for the Feb. 20 options chain is projected to range between $123.10 and $159.76. This dispersion implies a 12.96% high-low spread relative to the current spot price.

Where did this dispersion come from? Black-Scholes is essentially an elegant mathematical model that assumes stock returns are lognormally distributed. The aforementioned range represents where DDOG stock would symmetrically fall one standard deviation away from the spot price (while accounting for volatility and days to expiration).

Of course, most traders will recognize a lognormal distribution as a major presupposition. Further, while it's likely true that DDOG stock will trade within one standard deviation from spot, we have little clue as to what price range is probable. To say that DDOG can be anywhere between $123 and $160 is a 30% parameter. That doesn't give us a whole lot to work with.

To narrow the search for alpha down, we can apply a second-order inductive analysis using the Markov property. Under Markov, the future state of a system depends entirely on the current state. In other words, forward probabilities should not be calculated independently but rather assessed under context. To use a simple sports analogy, a 20-yard field goal is an easy chip shot. Add snow, wind and playoff pressure and these odds may change quite dramatically.

For DDOG stock, the current context is that in the trailing 10 weeks, it printed only three up weeks, leading to an overall downward slope. Under this 3-7-D sequence, forward 10-week returns would be expected to range between $130 and $170, with probability density peaking between $153 and $161. This is significant because under aggregate conditions, 10-week returns would be expected to range between $135 and $155.

Interestingly, over the next five weeks, most median outcomes would likely range — under the framework of this Markovian model — between $150 and $165, with probability density peaking near $158. This gives us a much narrower range to target.

Going For Gold With Datadog

Based on the market intelligence above and with the company's upcoming fourth-quarter earnings report — scheduled for Feb. 10 before the market open — I'm tempted with enhancing expected value while balancing probabilistic reality. With that in mind, the 155/160 bull call spread expiring Feb. 20 is speaking to me.

Through this aggressive but arguably rational call spread, you would execute two simultaneous transactions on a single ticket: buy the $155 call and sell the $160 call, for a net debit paid of $145 (the most that can be lost). Should DDOG stock rise through the $160 strike at expiration, the maximum profit would be $355, a payout of nearly 245%.

Yes, the trade is aggressive but the $160 strike falls well within the expected forward distribution of the 3-7-D sequence. Also, the breakeven price sits at $156.45, which is near the rising end of peak probability density. This structure enables us to have a solid chance to protect our capital while stretching for a sizable payout.

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