IBM Stock Just Suffered a Gruesome Massacre, But Algos Likely Sense a Huge Discount Here

Frankly, International Business Machines’ (IBM) technical chart may need to be disclosed with an NC-17 warning. Up until last week, IBM stock at least had its head above water. Unfortunately, that head — along with other body parts — has been fully detached thanks to an Art-the-Clown-style massacre ala the “Terrifier” franchise.

Indeed, the ugliness has yielded a 48% Sell rating from the Barchart Technical Opinion indicator, an ignominious endorsement that wouldn’t have happened were it not for Big Blue’s weak preliminary second-quarter earnings report. Because the disclosure had serious implications for the disruptive potential of artificial intelligence, the shockwaves weren’t just limited to IBM stock.

Obviously, Big Blue isn’t for the faint of heart. If you’re not the type to rush into a firefight, you should leave IBM stock alone. However, if you’ve got the speculative blood flowing in you, the badly beaten ticker makes an awfully compelling case.

Essentially, the modern equities market is dominated by algorithmic, rules-based trading by sheer necessity. Think about the flow of information. In the very instant that critical data becomes public, elite, institutional players have already dissected and digested the news seven ways to Sunday. When your paradigm operates in nanoseconds, nobody is waiting around for a newsletter to make a recommendation.

As such, when a retail trader attempts to play the information latency game for near-term options strategies, they are likely to be obliterated. Frankly, the system is engineered to bleed liquidity from the public. So, rather than willingly walk into a trap, we need to play a different game — the one that involves empirical distribution modeling.

It comes down to this: we don’t really care why the market is doing what it’s doing, in part because whatever answer we provide is likely to be wrong. Instead, we need to figure out how future outcomes are influenced by specific, quantitative triggers. Only then, I argue, will we be able to identify potential opportunities.

IBM Stock is Experiencing Déjà vu

On April 29, when IBM stock would eventually close at $227.10, I stated in a Barchart article that speculators should consider the 245/250 bull call spread expiring June 18. As it turned out, on that day, IBM closed at $249.10, which was very close to the second-leg strike. What’s more, just one day earlier, shares closed at $262.35.

By that point, the spread was worth between $4.90 to $4.95 (the difference between the two strikes minus remaining time value). No one’s going to risk that much profit just to secure an extra 5 to 10 cents per spread. So, how did I call a specific price and time target seven-and-a-half weeks out? I based my forecast on the balance of order flow.

At the time of publication, IBM stock had printed only four up weeks in the last 10 weeks, resulting in an overall downward slope. Conditioned for this 4-6-D sequence, the expected forward distribution over the next 10 weeks was projected to land “between $220 and $270, with probability density estimated to peak at around $250.”

As such, the $250 second-leg strike price was no accident. Additionally, I highlighted the thinnest spread possible, meaning that the gap between the first and second leg was minimal. That meant little margin for error, meaning that I had to be statistically confident that IBM stock would reach the target. However, the data consistently demonstrated that when IBM flashed the 4-6-D signal, $250 was the median outcome.

Most likely, this framework is at least partially effective because of how modern markets work. When the balance of order flow was bearish, the algorithms likely viewed IBM stock as a discount. And that’s why I’m excited about Big Blue right now. It’s flashing the same 4-6-D signal that it did in late April.

Adjusted for the latest closing price of $217.07, we would expect a forward 10-week distribution between $210 and $240, with probability density peaking at $228. Because the recent drop in IBM stock was so steep, a target price of $230 wouldn’t be out of the question — and that leads us to an intriguing options trade.

Putting the Numbers Together

In terms of exploiting the above data, I’m tempted with the 225/230 bull call spread expiring Aug. 21. Should IBM stock rise through the $230 strike at expiration, the maximum payout would clock in at over 127%. Breakeven stands at $227.20, meaning that Big Blue must be cooperative for this spread to be worthwhile. Because of the improbable nature of the trade, Wall Street assigns a probability of profit of only 40.2% that traders will break even.

Although this figure sounds terrible, it’s derived from the Black-Scholes model, which incorporates implied volatility to represent the distance (in standard deviations) the spot price is from the target threshold, assuming a risk-neutral, log-normal distribution. In simple terms, the probability is a theoretical one, involving a mishmash of geometric Brownian motion, partial differential equations and Feynman-Kac theorems.

However, my model proposes that future outcomes are not fixed to a parametric formula but rather is influenced by the balance of order flow. More to the point, my probabilities stem from observations, as in what you see is what you get.

Of the 44 times that the 4-6-D signal has flashed on a rolling basis since January 2019, IBM stock has exceeded the $227.20 breakeven price 23 times on week 6. Therefore, I would argue that the observed, empirical probability of profit is 52.3%.

On its own, that’s not great. Still, we’re talking about a gap of 12.1 percentage points in your favor. Essentially, the 225/230 bull spread is underpriced relative to the observed, historical risk you are taking.