How Volatility Clustering Could Trigger a Comeback in Baker Hughes (BKR) Stock

Baker Hughes (BKR) may represent one of the more difficult energy sector names to decipher. While the year-to-date performance of BKR stock is strong at over 28% up, its more recent performances have been choppy. As a result, the Barchart Technical Opinion indicator rates the ticker as a noncommittal Hold, though it notes that the short-term outlook is bearish.

It’s not surprising that BKR stock carries a cloud of skepticism. Although the market received Baker Hughes’ second-quarter earnings report well, the energy equipment specialist did suffer a year-over-year decline in the top line. In addition, uncertainties surrounding the Iran conflict has weighed on investor sentiment.

At the same time, there are counterbalancing positives to consider. Management emphasized its strong order momentum and execution of upstream energy infrastructure. Further, the leadership team stressed that its business features a diversified portfolio which has aided in adjusting to Middle East volatility.

Given the back and forth, BKR’s volatility skew for the options chain expiring Aug. 21 shows what appears to be a “smile” surface. However, the context leans toward downside protection, with peak implied volatility (IV) for out-the-money (OTM) puts reaching 124.6%, whereas OTM call IV peaks at 93.47%.

Basically, over the next roughly four weeks, smart money traders anticipate scenarios where Baker Hughes stock could either swing higher or incur a sizable correction. Because neither outcome commands a high-confidence probability, sophisticated market participants are hedged for both directions.

Theoretically, you could use the Expected Move calculator to anticipate what the present IV means for the future pricing profile of BKR stock. From there, you could buy a condor-like options strategy, betting on both an upside and downside move.

However, the problem with debit-based condors is that they’re expensive. Plus, if the target security doesn’t clear either profitability threshold, you would risk losing the “double” debit you paid. If you think BKR stock is going to lean toward a particular direction, it may be better to go with a singular trade.

Explaining the Power of Discontinuous Forecasting for BKR Stock

One of the underappreciated elements of options pricing is that the practice assumes a continuous pathway for valuation discovery. This continuity also impacts the implied probability of various options strategies — and thus how much money you end up risking. But because real-life market conditions often generate discontinuous pathways, knowing when this discontinuity may occur may give you a serious advantage.

And that’s my point about Baker Hughes stock. Because the ticker has suffered an extended period of downturns — at least from a quantitative perspective — this bearishness may affect how market participants view BKR. In other words, after suffering a streak of negative sessions, the algorithmic, rules-based protocols that dominate the modern equities market may end up buying the dip.

In that case, the buying pressure would be typically greater than what would normally be expected under ‘standard’ conditions. This dynamic may raise the probability of a volatility cluster, enabling traders who recognize the pattern ahead of time to exploit the potential trend.

Under a continuous pathway model, every forecasted unit of distance away from the current spot price leads to a decline in probability. For example, if the probability that a particular stock will rise from point A to point B is 60%, a rise from point A to point C is necessarily probabilistically lower, perhaps 55%.

In contrast, a discontinuous pathway model doesn’t share that linear assumption. In this system, the probability of the above stock reaching point B from point A could also be the same probability as reaching point C; that is, 60%. In this situation, it would be better to consider an options strategy with a target strike price of point C (if the reward potential is higher) since you’re absorbing the same expected risk.

An Order Flow Imbalance Could Lift Baker Hughes Stock

Now, why am I intrigued by the bullish case for BKR stock? It’s because the ticker suffers from an order flow imbalance. In the last 10 weeks, only two of the weeks have been positive sessions, thus leading to an overall downward slope.

Ordinarily, this framework would be considered pessimistic. However, under this 2-8-D quantitative sequence, the market has historically bought this signal. Subsequently, the expected forward 10-week distribution of outcomes would be expected to range between $55 and $70 (assuming a starting price of $58.46). Under a random 10-week hold, the expected distribution is only between $57.50 and $61.

Even better, in the fourth week following the flashing of the above signal, the median expected performance boost is around 9.48% up. Based on prior market trends that materialized after this quant sequence, there’s an inductive case to be made that Baker Hughes stock could reach around $64 to $65 at the end of the Aug. 21 expiration date.

To be sure, the laws of nature are not guaranteed to repeat. Also, there’s an extremely small sample problem with this analysis because the 2-8-D sequence is so rare. Stil, the rarity is also what makes BKR stock intriguing. For what it’s worth, the p-value for this expected pattern is calculated as 0.0202, meaning that there may be something more than random noise that’s causing BKR to move strongly following this signal.

A Possibly Mispriced Opportunity

With the inductive data in mind, I’m looking at the 60/65 bull call spread expiring Aug. 21. On paper, it’s a wildly optimistic options trade, which is a good part of the reason why Wall Street provides a maximum payout of over 270%. At the same time, the probability of profit that BKR stock will hit the $61.35 breakeven price at expiration is only 30.3%.

Remember, though, that this calculation stems from a continuous price pathway model (i.e. Black-Scholes). If you look at other spreads with the same second-leg strike, such as the 55/65 bull spread, the breakeven price is lower at $59.60, thus leading to a higher probability of profit of 41.8%. However, the max payout drops steeply to 117.39%.

Here’s where a discontinuous pricing model may identify a favorable mispricing. Of the 13 times that the 2-8-D signal has flashed since January 2019, BKR stock has exceeded the equivalent of the $61.35 breakeven price a total of nine times at the end of week 4 (Aug. 21). Under a discontinuous pricing framework, the profit of probability may be much higher at 69.2%.

Why the glaring gap between the two models? Historically, under 2-8-D conditions, Baker Hughes stock tends to enjoy positive volatility clustering. Rather than the ticker rising in stepwise fashion, it typically jumps from one threshold to another. Continuous models are mathematically blind to these jumps while discontinuous models reflect them.

To reiterate, there are no guarantees in the equities market. However, the data shows that the 60/65 bull call spread expiring Aug. 21 isn’t as silly as it initially seems.