As a major defense contractor, Northrop Grumman (NOC) is a well-known entity. Because of this fact, everything there is to know about the company — at least what is publicly and legally available — has already been absorbed. Stated differently, it’s unlikely to trade NOC stock based on an informational arbitrage; that is, the market not reflecting critical fundamental data into the NOC share price.
However, there could be a probabilistic arbitrage at play. Standard risk modeling such as Black-Scholes (for European options) or the Monte Carlo approach (which involves running multiple simulations) run into a potentially critical flaw: the assumption that pricing or volatility follows a log-normal distribution. This is a mathematical way of saying that the probability of a market event is assumed to be stationary or static.
It's easy, perhaps intuitive to believe this because in games of chance, future outcomes are independent of whatever happened before. For example, in a dice roll, the probability of rolling a six is always one out of six, irrespective of the prior action. Again, the previous outcome has no material effect on the next.
However, that can’t possibly be true in the stock market. Yes, major indices such as the S&P 500 may exhibit long stretches that may resemble a log-normal distribution, which is largely explained because the equities sector generally sees consistently heavy activity daily.
In contrast, specific securities will feature a dynamic ebb and flow — a sinusoidal trajectory that reflects what happened in prior sessions. After all, relative price represents one of the biggest (if not the biggest) reasons why human investors ultimately decide to buy, sell or hold.
Long story short, a stock’s price represents a dependent variable, not an independent one. And this framework favorably narrows the list of rational trading ideas to a selectively small range.
Use the Unusual Options Volume in NOC Stock to Your Advantage
A major clue that standard risk modeling may be flawed centers on the unusual stock options volume screener. This informational database showcases securities that have witnessed aberrant trades relative to normal sessions. So, it wouldn’t make sense to treat the NOC stock price moving forward as an independent variable.
Being listed on the unusual options screener may influence other traders — how could it not?
What adds to the case that investors should pay attention to NOC stock is the weight of the activity. On Friday, total option volume reached 12,575 contracts against an open interest reading of 27,481 contracts. The difference between Friday’s volume and the trailing one-month average metric came out to 699.94%.
Interestingly, call volume landed at 2,258 contracts while put volume soared to 10,317 contracts. This pairing yielded a put/call volume ratio of 4.57, which seems at face value to be unsightly. Such a ratio suggests there are way more traders buying put options than calls.
However, options flow data — which focuses exclusively on big block transactions likely placed by institutional investors — offers critical context. Here, net trade sentiment clocked in at $704,100, conspicuously favoring the bulls. Therefore, the large volume of puts were sold, which has neutral to positive implications.
However, the kicker could be the statistical evidence. From a stochastic or temporal view of the past five years’ pricing data, a position entered into NOC stock at the beginning of the week has a 51.88% chance of rising by the end of it. The long odds slip to 49.05% over a four-week period, which isn’t great.
Still, investors must keep in mind that last week, NOC stock suffered a loss of 6.58%. Such losses are rare. The median loss under a negative week lands at only 1.62%. What’s more, whenever NOC loses between 5% and 10% in a one-week period, the subsequent week’s long odds skyrocket to 81.82%.
While this stat seems incredible, over a four-week period following an extreme-fear event, the long odds remain attractive at 63.64%. There’s an incentive to bet on NOC stock that few analysts (if any) are appreciating.
One Trade That Stands Out
Unfortunately, Northrop isn’t the most commonly traded security so there are only monthly options available. The next expiration date is Feb. 21. However, that’s fine for our purposes because the odds of long-side success are the highest in the week following an extreme-fear event.
Based on dynamic projections, I anticipate that NOC stock will rise above the implications found in static risk modeling. Specifically, I see a scenario where NOC could rise to $456.38 by this Friday. Therefore, the 450/455 bull call spread appears the most attractive. This trade will need the stock to hit $455 or higher to collect the maximum reward, which is $195. To enter the transaction, you must pay $305.
If I’m being blunt, the 64% payout isn’t the most attractive. However, this may be the most aggressive bull spread that’s still in the realm of rationality — and I would argue probability.
