Options Corner: AI Industry Confusion Has Created A Massive Contrarian Opportunity In Unity Software

Unity Software Inc (NYSE:U) generated headlines for all the wrong reasons when its shares stumbled badly following an announcement by tech juggernaut Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL). Google introduced an experimental research prototype powered by its Genie 3 world model that enables users to create and explore interactive worlds. Undergirded by artificial intelligence, it appears to be another example of high-level disruption, which cratered U stock.

Essentially, the fear is that Genie 3 can usher in a paradigm that would clash with traditional game development platforms and publishers. While this may certainly conflict directly with upstream video game developers — with Genie 3 operating at the heart of the content-generation axis — Unity sits more downstream in the value chain. Specifically, it focuses on the execution and runtime axis of the gaming industry.

In other words, Unity is focused on functionalities such as real-time rendering, physics and memory constraints and performance under load. It's not centered where Google has its cross hairs: scene and environment creation, ideation acceleration and cost efficiencies of starting a digital world. Therefore, it seems that the U stock implosion is largely based on a misunderstanding.

Please note that the above isn't based on a hand-wavy narrative. If you look at volatility skew for the Feb. 13 options chain — which will be two days after the company's scheduled release of its fourth-quarter earnings report — you'll notice that implied volatility (IV) for call options on the upper strike price bounds are prioritized over put IV. Further, you'll see that call IV stands higher on the lower bounds as well.

IV is a residual metric that stems from actual order flows. When IV is elevated, it means there is an expectation of greater kinetic throughput. As such, the premium — which acts like insurance money — to protect against this volatility rises.

Right now, the volatility skew shows that this insurance money is being used to prioritize protection against upside volatility, not downside. Basically, the smart money isn't scared — and that's probably because it sees Google's competition as orthogonal, not direct.

Pushing Past The Limits of First-Order Analyses

While volatility skew shows the sentiment structure for a particular options chain, it doesn't give us a tangible range to target. The curvature in the skew doesn't actually reveal the specific strike prices that are being targeted. Instead, you can think of the curvature as a surface-level distortion stemming from elevated trading activity.

To get an idea of the actual parameters of the battlefield, we can turn to the Black-Scholes-derived expected move calculator. For the March 20 expiration date, the model anticipates that U stock will land between $23.13 and $37.21. This dispersion represents a 23.35% high-low spread relative to the current spot price.

Where did this dispersion come from? Basically, Black-Scholes assumes a world where stock returns are lognormally distributed. The above range represents where Unity stock will likely end up if it fell symmetrically one standard deviation away from the spot price (while accounting for volatility and days to expiration).

From a top-down perspective, the dispersion is reasonable because most stocks will fall within one standard deviation from spot (which is about where 68% of outcomes will land). Of course, the problem is that the absolute split between the two numbers is nearly 61%. We need a way to narrow this field down, which is where a second-order inductive analysis using the Markov property come to mind.

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.

And what is the context for U stock? In the trailing 10 weeks, Unity printed only four up weeks, leading to an overall downward slope. Under aggregate conditions, we would expect the security to range between $29 and $31 over the next 10 weeks. However, under 4-6-D conditions, the likely range would expand to approximately $26 and $36.

To be fair, there will likely be two peaks in probability mass, the biggest one coalescing around $30, thus indicating downside risk. However, the bulk of probability mass is projected to land between $31 and $35, suggesting that the bulls have the wind at their backs.

Taking The Smart Contrarian Bet

There are pure contrarian bets which hardly anyone is considering and then there are examples like Unity stock, which falls under the category of smart contrarian bet. It's smart because the most sophisticated market participants are showing their hand by distorting the volatility skew in favor of upside optionality.

That's an awfully convoluted way of saying that even though U stock is a "discount" in the open market, it's actually quite expensive in the options market. So no, you're not getting a good deal on Unity call spreads. Basically, the smart money sees upside in the stock's future.

Still, in terms of groupthink, this is probably the best kind. Currently, the public money is panicking. By contrast, the smart money is buying. Ultimately, it's up to you to decide based on the power of the evidence.

Personally, I find the volatility skew and inductive analysis convincing because they help narrow uncertainty from an information theoretic standpoint. Right now, I'm liking the 33/34 bull call spread expiring March 20, 2026.

This trade only requires a net debit of $43, which is the most that can be lost. Should Unity stock rise through the $34 strike at expiration, the maximum profit would be $57, a payout of roughly 133%. Breakeven lands at $33.43, adding to the trade's probabilistic credibility.

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