Options Corner: Palo Alto Networks' Non-Negotiable Business Presents A Compelling Discount

Palo Alto Networks Inc (NASDAQ:PANW) couldn't escape from the fallout in the tech sector amid rising geopolitical tensions. Tensions in the Middle East appeared to influence investors as they shifted away from growth names and into safe havens like gold. Still, cybersecurity represents a non-negotiable element within the broader innovation ecosystem. As such, PANW stock would seem to be a discount — and that's exactly how the smart money is playing it.

As Ritholtz Wealth Management's Josh Brown colorfully explained in a podcast last year, cybersecurity represents the one line item that enterprises can't afford to cut, irrespective of economic headwinds. True, executive teams are looking for ways to slash expenses amid an increasingly challenging environment. However, the cost of a single major cyberattack could lead to an out-of-business impact.

Of course, we can wax poetic about these obvious narratives but what's much more convincing is that the smart money apparently has the same posture. Volatility skew, which is a screener that identifies implied volatility (IV) or a stock's potential kinetic output across the strike price spectrum of a given options chain, reveals hedged optimism for PANW stock among sophisticated market participants.

For the March 20 expiration date, both call and put IV are nearly symmetric around the spot price, which indicates that the market is not paying an excess fear premium for immediate downside protection. That's significant because if downside represents the dominant theme, we will likely see put-side IV spike noticeably higher.

Because of the holistic positioning in the options market, we see a surface-level distortion that has caused both put and call IV to rise gradually at the edges. Generally, this setup indicates that while smart money traders recognize downside as a non-trivial risk, they're also pricing for upside convexity.

In other words, sophisticated traders don't appear to be panicking. They likely view PANW stock as a viable opportunity — they just want some insurance to go with the position. In effect, we have the highest-quality form of contrarianism: public money fear versus smart money optimism.

Treating PANW Stock Like A Shipwrecked Survivor

While we may understand the general sentiment of options traders, we're still at a loss as to how this translates into the forward PANW stock price output. For that, we can turn to the Black-Scholes-derived expected move calculator. The financial model — which is Wall Street's standard mechanism for pricing options — reveals a parametric range of between $144.30 and $183.46 for the March 20 expiration date.

Where does this dispersion come from? Black-Scholes assumes a world where stock market returns are lognormally distributed. Under this framework, the above range represents where PANW stock may symmetrically land one standard deviation away from spot (while accounting for volatility and days to expiration).

If you want to skip all the math, it really means that in 68% of cases, PANW stock should trade between roughly $144 and $183 when March 20 rolls around. That's a great insight because it frames the parameters of the battlefield. However, it's also a bit like saying that our search zone is a large section of the Pacific Ocean as opposed to the Atlantic.

Like a search-and-rescue team, we as debit-side traders have very limited resources. Frankly, not every shipwreck incident merits a full-scale effort. Because the search area is so vast — in this case over 27% ($183.46 divided by $144.30) — we need some way of probabilistically determining where the survivors are.

This is where the limitations of the Black-Scholes model become obvious. Because the model calculates its forward probabilities independent of context (such as ocean currents, to extend the analogy), we only have a perfectly symmetrical parameter relative to spot. Probabilistically, though, the shipwrecked survivors have likely drifted one way or another.

We need a model to accommodate this drift and that's where the Markov property comes into view.

Using A Markov Model To Trade Palo Alto Networks Stock

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.

In the case of PANW stock, the present context is that, in the last 10 weeks, the security printed only two up weeks, leading to an overall downward slope. There's nothing special per se about this 2-8-D sequence. However, this quantitative signal represents a specific type of ocean current — and that means this current will likely influence PANW in a way that's different from other currents.

Think of it this way: a shipwrecked survivor will almost certainly drift differently in calm waters versus choppy waters. Therefore, the 2-8-D sequence represents a specific type of moving water dynamic. Based on enumerative induction and Bayesian-lite inference integrating the Markov property, we can estimate that, over the next 10 weeks, PANW stock should land between $155 and $190, which is admittedly a wide dispersion.

However, here's the difference between this output and Black-Scholes: most of the probability mass should land above the spot price. Further, we would expect peak probability density under 2-8-D conditions to materialize between $170 and $177. That's a much tighter range to target.

Given the market intelligence above, aggressive speculators will likely appreciate the 175/180 bull call spread expiring March 20. For this trade to be fully profitable, PANW stock will need to hit $180 at expiration, which is a realistic target based on both my Markov model and Black-Scholes. If it does, the maximum payout would be a bit over 170%.

Perhaps most enticingly, the breakeven price sits at $176.85, which is very close to peak probability density.

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