Options Traders: Xcel Energy (XEL) Stock Just Might Offer Robust Positive Expectancy

I’ll just cut to the chase: Xcel Energy (XEL) could be undervalued relative to the risk that options traders have historically faced under similar circumstances. To be fair, XEL stock isn’t viewed as a compelling opportunity by the market. For example, the Barchart Technical Opinion indicator rates the ticker as a 40% Sell — and it’s not an unjustified position.

Sure, XEL stock is in positive territory on a year-to-date basis, although it has only gained a modest 4.52%. However, the journey itself has been wildly choppy, meaning that your perspective on the underlying investment may vary depending on when you entered the position. For example, in the trailing month, XEL is down nearly 4%.

However, for the aggressively optimistic trader, the market is currently offering an intriguing proposition. Looking at the 80/85 bull call spread expiring Sep. 18, this trade offers a maximum payout of over 376% should XEL stock rise through the $85 strike price at expiration. Nominally, your $105 net debit required could translate to a profit of $395.

Of course, when something sounds too good to be true, it usually is — and that’s especially the case on Wall Street. So, the catch here is the probability of profit of only 26.9% that XEL stock will hit the breakeven price of $81.05 at expiration.

Basically, the implication here is that if the odds are only 26.9% that the trade will merely end in a draw, then the chance that Xcel Energy stock will trigger full profitability (at $85 on Sep. 18) is microscopic. As such, the way this trade is presented to us translates to negative expected value (EV).

That makes sense conceptually. If you have a shot of receiving a gargantuan reward, you’re going to have to accept gargantuan risk. But what if there was an alternative probability of profit?

Could XEL Stock Options be Favorably Mispriced?

Conceptually, options pricing is one of the messiest formulations ever. That’s why Black-Scholes and its derivative frameworks are so important. When you buy an option, you are buying a forward-looking contract. Unlike buying a stock — where you own a static slice of current equity — an option’s price is heavily weighted by the probability distribution of where that stock might land in the future (extrinsic value)

Obviously, no one knows the future so there has to be some kind of standard mechanism to determine what the perceived risk of the target derivative is to not make money. So, when you buy an option, it represents the “fair value” of what you should pay today for the risk you will likely incur tomorrow.

But who arbitrates the magnitude of risk that you will likely incur tomorrow? It’s a presupposition — much like when a religious person declares that there are only two places you go when you pass on. You can accept the presupposition or you might not; it’s really that simple.

However, in the options market, we can’t have everybody screaming at each other about whose presup should be the standard. That’s the political beauty of Black-Scholes beyond the mathematical elegance. It’s not a perfect indicator of the truth for the obvious reason that thousands of stocks have different personalities, for lack of a better word. But it is more or less the Wall Street standard.

Is that necessarily a bad thing? Absolutely not! Because now, if we have an alternative reason to trade outside standardized assumptions, that may benefit the retail trader. Fundamentally, one of the biggest reasons for alternative thinking is the assumption of the random walk.

Without getting too deep into the woods, the 26.9% probability of profit referenced earlier is the implied probability of Xcel Energy stock rising from the current spot price to the breakeven price, assuming XEL takes a random walk given current volatility metrics.

But if XEL stock took a nonrandom walk, the probability could be far different.

Walking Away from Standard Assumptions

I don’t think it’s controversial to say that most of us believe the equities market is nonrandom. Otherwise, if you genuinely thought the market was random, then there would be no point in looking for an edge (as the long-term outcome would converge toward 50/50).

Further, my presupposition is that when certain order flow imbalances occur (more negative sessions than positive over a defined time period), the market reflexively responds to the current circumstances. In the case of XEL stock, the ticker has printed only three up weeks over the last 10 weeks, leading to a downward slope. That’s a specific quantitative circumstance, which should warrant a distinct market response.

Keep in mind that I’m not saying that there’s anything inherently special about this 3-7-D quant sequence. What I am saying is that whenever this signal has flashed in the technical charts, the response has been an above-average level of performance.

What does this mean for XEL stock? Based on past empirical data, XEL experiences enhanced mobility — perhaps stemming from trading algorithms bidding up the relative discount. And this mobility results in an expected median endpoint of around $83 at the end of week 6 (which roughly coincides with the Sep. 18 expiration date).

Now, the chances of XEL stock hitting the $85 second-leg strike are very modest at only 28%. How did I arrive at this figure? After six weeks following the flashing of the 3-7-D signal (which has occurred 25 times since January 2019), the ticker has exceeded the equivalent of the $85 target price a total of seven times at the end of week 6.

On surface level, the 28% probability of full profitability may turn people off. But because the aforementioned  Sep. 18 80/85 bull call spread features a 376.19% max payout (at time of writing), this trade setup over the long run would be expected to deliver positive EV. Simply, while you would lose a lot, every time you win, the rewards would theoretically exceed the losses.

A Final Note to Consider

What makes the above trade interesting is the $81.05 breakeven price. Recall that this is the price where Wall Street has assigned a probability of profit of only 26.9%, meaning that the standard implied probability of full profitability is much lower.

However, if we were to assume a nonrandom walk (as defined by my model above), the observed, conditional probability of profit may be 64%. Of the 25 times that the 3-7-D signal has flashed, XEL stock has triggered the equivalent of the $81.05 breakeven price a total of 16 times at the end of week 6. So, it’s possible that the positive EV of the trade could be even more robust because there’s apparently a solid chance of partial profitability.

Now, it must be stated clearly that there’s no logical reason why XEL stock should continue to trade along observed median trends following the quant signal in question. That’s the fault line of any inductive model — the black swan risk can easily crush assumptions.

Plus, at the end of the day, Black-Scholes and I are in agreement: the chance that XEL stock can trigger the $85 strike on any given day at expiration is minimal. However, I believe that the path there is likely to be nonrandom — and thus the odds of success (partial or otherwise) may be better than advertised.