Options Corner: Why Broadcom's Pullback Statistically Favors A Defined-Risk Call Spread

Without question, artificial intelligence has sparked a paradigm shift in the business ecosystem, driving additional relevance for semiconductor specialists like Broadcom Inc (NASDAQ:AVGO). However, it’s also fair to point out that investors demonstrated signs of fatigue or at least rising concerns tied to excess valuations. In the trailing month, AVGO stock incurred a loss of roughly 10%. Still, the extended bearish pressure could offer a contrarian opportunity.

Although Broadcom consistently brings home the goods when it comes to earnings performances, the latest strong print wasn’t enough to bolster its lofty share price. Due to lower-than-expected AI gross margins, along with concerns about China’s chip competition, AVGO stock incurred a rush for the exits. On Dec. 17, the security closed at $326 before reflexive sentiment brought it back to around the $350 range.

As circumstances stand, there are two basic ways to approach AVGO stock, particularly from an options trading perspective. First, probably the most common approach is to rely on human (or perhaps non-human) interpretation of the various fundamental and technical factors influencing the price discovery process. Second, there is the quantitative approach, where practitioners attempt to uncover mispricings from empirical trends.

In other words, you can trade with your gut or with the data.

Realistically, it’s not an absolute either-or situation. Options trading is a lot like baseball. Ahead of the game, managers and players prep for the opposition  — and this preparation is very much quantitative. While outcomes obviously can’t be predicted with precision, the sport’s sabermetrics demonstrate that, over repeated occurrences, tendencies of where the ball is put into play materialize. Still, there’s also room for in-the-moment decisions, thus creating a dynamic environment.

Similarly, stocks also exhibit behavioral biases, depending on how they’re struck, so to speak. Therefore, the whole point of my quantitative approach to the market is that we can forecast how a security may respond given the current condition that is striking it. With this data, we can then make informed decisions by either playing the numbers or the flow of the game.

Leveraging Sports Science To Trade AVGO Stock

Anyone with a modicum of sports and physics knowledge inherently realizes that different batters strike the ball differently. Some folks take big hacks at the ball and suffer from a high strikeout rate — but when they make good contact, watch out! Other players prefer the high contact route, prioritizing getting on base rather than trying to win it all with one swing.

In my mind, that’s just like how quantitative analytics in the options market works. Right now, there’s a specific kind of batter at the plate for Team Broadcom. In the past 10 weeks ending Tuesday, AVGO stock printed an even count of up weeks and down weeks. However, the overall slope of this period was downward.

To better understand how the market will respond over the next 10 weeks, I can look back in my dataset (which starts from January 2019) and analyze how this sequence — which I’ll abbreviate as 5-5-D (five up, five down, downward slope) — has typically resolved.

Interestingly, under aggregate conditions, a random 10-week return would likely range between $334 to $386 (assuming an anchor price of $348.54). Further, probability density would likely peak at roughly $368, thus indicating a positive bias as AVGO’s natural behavioral tendency.

However, as we stated earlier, we’re not trading AVGO stock as an aggregate expression. Instead, we want to know how it responds to the 5-5-D sequence, which is the current quant signal. Under this regime, AVGO will likely range between $330 and $420, with probability density peaking between $368 and $385.

Effectively, what we have calculated is Broadcom’s risk geometry. We now know where AVGO stock is likely to peak given the underlying quant signal. We also know where we should back off.

Critically, between $380 and $400, the probability density of AVGO stock drops on a relative basis by 51.46%. From $400 to $420, density plunges by 99%.

Bear in mind, it’s not that AVGO hit $420 or even higher. Rather, from observed behaviors within the dataset, such an outcome is unlikely to materialize. Therefore, if we are going to gamble, it’s prudent to consider forward events that are probable, not merely possible.

A Compelling Idea Shines Through The Mist

Another element to consider is how frequently AVGO stock traverses the expected distribution of outcomes following the 5-5-D sequence. Through a three-dimensional view of demand structure, we can see that there’s heavy activity projected between $380 and $400. Essentially, this risk topography shows that after traversing price levels up to around $400, AVGO would tend to terminate at approximately $380 over the next 10 weeks.

Given this statistical tendency, I believe the prudent approach is to consider the 370/380 bull call spread expiring Feb. 20, 2026. This wager involves two simultaneous transactions on a single ticket or execution: buy the $370 call and sell the $380 call, for a net debit paid of $330 (the most that can be lost).

Should AVGO stock rise through the $380 strike at expiration, the maximum profit is $670, or a payout of 203%. Further, breakeven lands at $373.30, adding more statistical credibility to the wager.

Because of the forecasted heightened activity near $400, the most aggressive traders may be tempted with the 380/390 bull spread (also expiring Feb. 20). This transaction offers a max payout of almost 285%. However, I’m a big fan of the 370/380 spread as there’s a strong reward on tap — and it aligns closely with the data.

The opinions and views expressed in this content are those of the individual author and do not necessarily reflect the views of Benzinga. Benzinga is not responsible for the accuracy or reliability of any information provided herein. This content is for informational purposes only and should not be misconstrued as investment advice or a recommendation to buy or sell any security. Readers are asked not to rely on the opinions or information herein, and encouraged to do their own due diligence before making investing decisions.

Read More:

Image: Shutterstock