As the markets rallied this week, some may think this is the start of a new trend or rather, the continuation of the bull market. In this respect, I am sure many are looking at Microsoft's (NASDAQ:MSFT) all-time, split-adjusted high of $59.97 and hoping that the stock will continue to rise.
Fundamentally, increased revenues and earnings should result in higher prices over the long term. We supposedly have no indication on when or how much the stock will appreciate in a given time or do we?
Whether you like it or not, making money in the market is all about probabilities. You can have well rounded and thorough analysis, but if your analysis of the intrinsic value yields a low probability, there is not much point in placing too much faith and belief in your analysis or staying the course. This has been preached by the professionals, which in my opinion makes the individual investor helpless.
Unfortunately, these same professionals will not admit their flawed thinking. Instead, they will give the same trite advice. They will simply tell you to plunk more "dry powder" and defend their flawed thinking. (I know, I used to work for a financial advisor.)
This is where I believe the options market can help us equity investors. It provides a bit more context to the fundamentals and is a really good complement.
The there are two probabilities I look at: the probability of being in the money (ITM) and the probability of touch (POT).
*According to tastytrade:
Probability of touch predicts how often a stock will touch a particular price anytime between now and a certain date. Probability ITM is the probability a stock will close at least one penny beyond a certain price on expiration.
As stock investors, we really are not concerned with price just touching the level, we want price to break a level and continue higher. I will focus on the latter, the probability of being in the money.
Let's focus on the analyst price targets for this analysis.
Analyst price targets
Yes, I bring these up again because I really do not believe such whimsical targets are helpful. They feed on human need for certainty in an uncertain environment. However, they can be useful if some context is provided around these numbers. I, for one, would respect these guys if they threw in a probability for their targets, not the typical 1 to 2 sigma levels that basically gives them a wide range to be wrong, like this forecast for the S&P 500:
Based on current valuations, a regression analysis suggests compounded annual returns of 8 percent over the next 10 years with a 90 percent confidence interval of 4-12 percent.
Below is a table of a few price targets and their probabilities. I am very amused that the median target is the previous all-time high. A historical chart will yield that level as clear as day. The only logical explanation is that analysts are using the historical price on the chart and creating fundamentals to support the all-time high. So much for not being bias. While it is possible to create myriad justifications for the price, the probabilities do not lie. There is only one way to interpret them.
Source: Yahoo Finance
I used the ThinkorSwim platform that provides the probabilities listed below. I only used the high and median targets. To avoid confusion, I looked at the upside targets using call options.
Source: Self-created using option chain data from ThinkorSwim
Assuming that the stock has a 50/50 chance of going up or down on a given day and based on the current information, we can conclude the following:
- Even though the probability of the stock being above the $60 mark increases to 20% at the end of January next year, it tells us in all likelihood to not bet on such a move. You will do better with a coin toss than betting on the stock to the specified level.
- The last target of $70 is unreasonable. Yes, analysts back their data up with fundamentals, but the statistics show the absurdity of their analysis. Currently, less than 10% chance across the months.
Notice as each month goes by the probabilities slightly increase. This is because of the notion of time value. The more time you allow a stock to move, there is an increased likelihood of moving toward the target. However, be mindful of the fact that these odds are still not in your favor.
When an analyst comes on CNBC to give an updated price target for "near-term" events, I check the probabilities to see the likelihood of occurrence.
Combining these probabilities with your assumptions can open up an new form of analysis. Just as fundamentals and technicals change, so do the probabilities, but they help provide context about what is occurring in the markets.
I firmly believe the days of pure fundamental analysis are a thing of the past. To be successful in this market, we need to stop speculating and use the statistics options provided to make better decisions.
(While this is an overview, I do hope to provide more insight if there is any interest.)
*From a slide in the video.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.