Hewlett-Packard and Regression to the Mean

When Hewlett-Packard was getting pummelled in November 2012, and deservedly so, I discussed the situation in the article Simon & Garfunkel and the Situation of Hewlett-Packard .

HP guided much below the analysts' estimates for Q1 2013 and then on November 20, it announced that:

In response the stock hit its multi-year low of $11.35, valuing the company at $22 billion. Meanwhile, I made following trades:
:20 Nov 2012: HPQ 18Jan14 $18 Call +[email]200@0.41[/email]20 Nov 2012: HPQ 17Jan15 $10 Call +[email]100@3.05[/email]
I was quite certain that the market was over-reacting and given time the stock will go up. Since then the stock has recovered quite nicely to $20.5, a nearly 80% increase in price.

This does not mean that I was astute or the turnaround of HP is on its way. This is what the statisticians call "regression to the mean."

Regression to the mean is a fancy way to say that things get back to normal. Extreme circumstances do not last forever. This has several implications.

Suppose that in a given year an actor has done very well. All his movies have done good business and his acting was appreciated by critics and the viewers alike. He also got the Oscar for the best actor, and magazines ran cover stories on him. If one has to guess his situation for the next year, what would be the best way?

The success of the actor in a given year can be thought of as having two components: Ability and luck. It is not enough to have great acting prowess -- one also needs to be lucky. Luck is fickle by nature. If you are very lucky today, it is unlikely that you will be lucky tomorrow, too. So, the actor's standing in the next year is going to be (more likely) worse than this year.

Daniel Kahneman has a very good way to explain it. To arrive at a prediction of the actor's next year we start with:

Success = ability + luck

For the next year, we will start with the baseline success of the actor and then adjust the prediction according to the ability of the actor in question. We will give no weight to the luck because the actor cannot count on the luck being with him two years in a row.

This situation gives rise to something called "Sports Illustrated Jinx." The jinx says that a player/team featured on the cover of "Sports Illustrated" is likely to have a disappointing year the following season.

But we know that a player/team feature on SI is likely having a great year in terms of luck and is on "top of its game." And the most likely direction from "the top" is down.

I sold these options at a handsome profit.

:Jan 3, 3013 HPQ $18Jan14 Call SLD [email]200@1.49[/email] = profit $214Mar 5, 2013 HPQ $10Jan15 Call SLD 100@10.5 = profit $745

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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