Reddit’s Severe Pullback May Offer a Coiled Spring Opportunity for RDDT Stock Options

It doesn’t take a market expert to realize that Reddit (RDDT) has suffered a severe setback. Following its second-quarter earnings disclosure — where a dark cloud surrounding Google’s AI search threatening user traffic and growth trends dominated proceedings — investors had to digest escalating concerns tied to machine intelligence’s disruptive potential. Subsequently, RDDT stock dropped 21% last Friday.

As Barchart contributor StockStory mentioned, the “main concern for investors was uncertainty around how users will find Reddit as Google increasingly uses AI-generated summaries instead of traditional search links. This change threatens Reddit's referral traffic, a key source of its audience. The issue was highlighted by slowing domestic daily active user growth of 5.8% and CEO Steve Huffman's comment that search referrals had become ‘choppy’ during the quarter.”

As a result of the skepticism, investors are pensive in their approach to RDDT stock. Right now, the Barchart Technical Opinion indicator rates the ticker as a 24% Weak Sell, with concerns that it will continue to suffer near-term volatility. On a year-to-date basis, Reddit now finds itself down nearly 39%. That means that investors who spent $1,000 on the company’s IPO are now looking at an investment worth $2,775.

Still, as StockStory explains, there’s still a positive wrinkle here. “While Reddit depends on Google for traffic, the leverage doesn't just lie with the search giant. Reddit's vast repository of human content, which boasts high trust among consumers and high commercial intent that is coveted by advertisers, is increasingly valuable for AI training in a world increasingly dominated by AI-generated content (aka ‘slop’). Google is further incentivized to sign a deal with Reddit to keep Reddit's data out of the hands of key competitors also looking to train their AI models.”

Even better, there’s a quantitative bullish case to consider for Reddit stock.

Path Dependency Holds the Key to Trading RDDT Stock

Before I get into the optimistic argument for Reddit stock, it must be stated clearly that this position is extremely speculative. Consider the volatility skew for the options chain expiring Sep. 18. You can definitely say that the volatility surface for near at-the-money (ATM) options (both calls and puts) is relatively flat, suggesting a neutral sentiment among the smart money.

However, look at the wings of the volatility skew. You can clearly see what is known as a volatility smirk. That’s when the implied volatility (IV) — or the market’s anticipated movement of the target security — is skewed heavily toward far out-the-money (OTM) puts (at 123.24%) versus far OTM calls (at only 89.32%). To be fair, there’s some exposure to upside convexity but the dominant posture is downside risk protection.

It can’t be helped: if you’re going to make a debit-side options trade on RDDT stock, you are making a contrarian bet against the fundamentals and the so-called Greeks (or options-based pricing dynamics).

However, the thing that you have to also keep in mind is that the Greeks are incorporated in a valuation engine that assumes path independence. In other words, because the standard Black-Scholes model is a static formula, the output is mathematically bound by the established parameters. And those parameters assume that underlying asset returns are lognormally distributed with a continuous geometric Brownian motion.

Of course, the problem is that real market returns are often chaotic and messy — especially after a market-moving event like earnings. In certain circumstances, volatility doesn’t glide up a lognormal scale, hitting every unit of measurement. Instead, as we saw with RDDT stock, highly mobile securities gap up or down. That’s where the term volatility cluster comes in.

Now, with empirical path-dependent models, we can better predict when these volatility clusters occur. In the case of Reddit stock, the ticker has only printed three up weeks in the last 10 weeks, leading to a downward slope. Historically, the flashing of this 3-7-D quantitative sequence has resulted in positive volatility clusters.

To be 100% clear, I can never be 100% positive that past trends will repeat in the future. Further, the relatively recent Reddit IPO means that I only have a rolling sample size of 15 occurrences to make my probabilistic case. If that’s too small, you can stop reading and look for another opportunity. But if you’re interested in taking the risk, I’ll share why I believe RDDT stock is underpriced.

Going for a High-Risk, High-Reward Trade

Essentially, the actionable thesis is this. At the end of the seventh week following the flashing of the 3-7-D sequence, Reddit stock tends to hit a median endpoint price of $160. As such, it makes sense (assuming the validity of the model) to consider the 155/160 bull call spread expiring Sep. 18.

This trade requires a net debit of $215, with speculators hoping that RDDT stock rises through the $160 strike at expiration. If so, the maximum payout stands at 132.56%. However, the mathematical highlight of this call spread is its breakeven price of $157.15. Right now, Wall Street assigns a probability of profit of 32.9%. That’s very low, practically guaranteeing a negative expectancy if you were to consistently trade these odds over the long run.

But what if I told you that these odds are academic and may not reflect reality? As I mentioned earlier, the Black-Scholes framework assumes that market returns are independent variables. More to the point, the model is responsible for pricing options, not for predicting options.

When traders use Black-Scholes, they are asking a nuanced question: given a risk-free rate and a specific volatility parameter, what does it mathematically cost to continuously delta-hedge this derivative so no riskless arbitrage exists?

I’m almost certain that 99% of you are not asking that question. Instead, you want to know where RDDT stock is going to end up at a particular point in time so that you can place a debit-side directional wager.

My answer is that out of the 15 times that the 3-7-D sequence has flashed, Reddit stock has exceeded the equivalent of the $157.15 breakeven price a total of eight times at the end of week 7. Observationally, then, RDDT has a probability of profit of 53.3%.

Granted, the problem of inductive analyses is that the repeatability of nature cannot be guaranteed. It’s not logically necessary for RDDT stock to hit $160 on Sep. 18. However, past data suggests that this outcome is more likely than an academic framework would suggest.