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At first glance, it’s natural to be apprehensive about MGM Resorts (MGM). Sure, MGM stock itself is ranked as a 40% Buy, according to the Barchart Technical Opinion indicator. Further, the technical profile suggests a continuation of the long-term trend. At the same time, the ticker faces significant economic headwinds.
I don’t need to list all the challenges associated with the devolving Iran crisis that have stymied recent progress for the casino and resorts giant. Las Vegas itself has undergone a sort of paradigm shift relative to pre-COVID norms. Factor in rising inflation and the soaring cost of energy and you have good reason to be skeptical of MGM stock, which has lost 2.47% in the trailing month.
However, it wouldn’t be fair to harp on the negatives in light of the company’s second-quarter earnings results. Last week, the hospitality specialist reported adjusted earnings per share of 59 cents on revenue of $4.45 billion, beating analysts’ consensus targets of 58 cents and $4.42 billion, respectively. Perhaps most importantly, analysts anticipate an improving convention and events calendar, which could boost sentiment.
But will that be enough to drive up MGM stock? In the near term, the smart money seems skeptical. In particular, the volatility skew for the options chain expiring Sep. 18 reveals what appears to be a put skew. Basically, implied volatility (IV) for far out-the-money (OTM) puts exceeds IV for far OTM calls. This dynamic apparently signals that traders are currently paying a higher premium for downside protection rather than exposure to upside convexity.
Of course, the volatility skew is not set in stone — it can easily change day to day, depending on a host of market-shifting information. Right now, a hidden quantitative signal could be forecasting a positive volatility cluster.
A Nonrandom Walk Could See MGM Stock Pop Higher
Options math is incredibly complicated. At the core, when you look at the price you need to pay for a debit-side transaction, the market utilizes a calculation from the Black-Scholes family of formulations to come up with the answer.
When you strip away all the complex math, Black-Scholes responds to the following question: given the perceived risk of this option contract hitting the breakeven point at expiration, what is the fair price that I should pay today? You should know that “perceived risk” is doing a lot of work here.
It’s impossible to know with 100% certainty what the true future risk is. So, the best that we can do is to approximate it. Black-Scholes’ answer is to take the current IV and run it through a fixed standardized pricing mechanism. Within this framework is the key assumption that the security in question undergoes a random walk.
So, the “probability of profit” is essentially the odds that the ticker breaks even at expiration, assuming that it takes a random walk from the current spot price to the end destination. My analysis centers on the philosophy that under certain conditions, the journey incurs a nonrandom walk. In the case of MGM stock, the data shows a tendency of encountering a positive volatility cluster — or a magnitude of volatility that drives much higher than what would be expected under a random walk.
Specifically, in the past 10 weeks, MGM stock printed only three up weeks, leading to an overall downward slope. I'm not saying that there’s anything inherently special about this 3-7-D quant sequence. But what it does show is an order flow imbalance: there are simply more down weeks than up. Historically, whenever this sequence flashed in the charts, MGM has exhibited positive nonrandom behavior.
If we were to extract forward historical trends, we would anticipate a median endpoint price of around $51.80 at week 6 (approximately in line with the Sep. 18 expiration date).
Identifying a Potential Trading Idea
I want to be clear that I’m making an inductive case for MGM stock, which comes with a serious caveat: the repeatability of nature cannot be guaranteed. Just because MGM has historically risen higher off the 3-7-D signal does not mean it’s logically forced to do so over the next six weeks. At the end of the day, nobody knows.
However, if you were to speculate based on the data, I would argue that the 47/50 bull call spread expiring Sep. 18 looks intriguing. Here, MGM stock must rise through the $50 strike at expiration to be fully profitable, which would translate to a maximum payout of 76.47%. The net debit required is $170.
Mathematically, though, the highlight of the trade is the breakeven price of $48.70. Right now, Wall Street is assigning a probability of profit of only 28.7%. Again, if MGM stock were to take a random walk from the current spot to the breakeven price, 28.7% would represent the realistic odds.
My argument, though, is that under 3-7-D conditions, MGM stock has historically exhibited nonrandom behavior. It’s the median price point of this conditional behavior where we get the forecast of $51.80 on Sep. 18. To be clear, I am not making a deterministic statement that MGM will end up there; I’m just saying that this price target has been the historical outcome under the specified conditions.
Moreover, out of the 28 times that the aforementioned signal has flashed on a rolling basis since January 2019, MGM stock has exceeded the equivalent of the $48.70 breakeven price a total of 18 times at the end of week 6 (Sep. 18). This may mean that the conditional probability of profit is 64.3%.
On the date of publication, Josh Enomoto did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
