As regular readers know, the purpose of RiskReversal.com is to help equity traders/investors understand the alternative ways they can express their views in the equity markets. One of our main goals is to detail the use of equity options to better define risk, enhance yield and make use of leverage in a cost effective way. Most of the trades that we detail on the site are trades that we put on ourselves, while often times we will detail hypothetical trades that we are considering and others that we see in the market that we find interesting. As regular readers know, we go out of our way to find what we deem to be suitable trade ideas for all levels of investors/traders, BUT normally we do not endorse trades that result in naked short option positions.
IN the normal course of our work we come up with numerous trade structures before we arrive at the one that we like the best, often times we put some into the “Adult Swim” category, meaning if we did not have capital or margin constraints, and if we did have a risk manager we would love to put on.
We have hundreds of readers who have been with us for more than a year, many since inception back in mid 2011 (we are very thankful to you!) and most have a sense for our risk tolerance, while many have asked that we detail some of what we would deem to be riskier option trades that we come up with. Ok Well people here it is, we are going to start posting them under the “Adult Swim” title, and we will say it very clearly in each post at the bottom. These are not trades that we are executing for ourselves or recommending to others, they are merely interesting trade structures that should be used as valuable learning tools.
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Let’s start with ADBE’s report tonight (Enis previewed last week, below), the implied move is about 5% which is basically inline with the 4 qtr avg and slightly above the 8 qtr move). The technical set up is interesting to say the least as the stock has held the uptrend that has been in place since Oct of 2012 and is now attempting to breakout of the 4 month range approaching the all time highs.
But here is the thing, with the stock up 28% ytd, and trading at 28x next years expected earnings, I think it is safe to say that expectations are exactly low. I want to lay out 2 trades that look interesting to me if I were very convicted, one long, one short, and if I were not worried about margin implications and the risks associated with being naked short options.
IF I WERE BEARISH:
ADBE ($48.26) Sell Sept 50 call to Buy the Sept 47/45 Put Spread for even $
-Sell 1 Sept 50 Call at .50
-Buy 1 Sept 47 Put for .70
-Sell 1 Sept 45 Put at .20
Break-Even on Sept Expiration:
Profits: If the stock is btwn 47 and 45 make up to 2.00 with max gain of 2.00 below 45.
Losses: above 50 you are short the stock, but 3.5% higher than current levels.
Neutral: btwn 47 and 50 no gain or loss
Trade Rationale:
If you were bearish and inclined to short the stock, but didn’t like the entry at 48.26 then this structure gives you some leeway to the upside with a very nice payout potential on a downside move in line with the implied move with no capital outlay.
MAJOR RISK: You are naked short calls, which is probably the most dangerous options position to have, but no riskier than short stock without protection.
IF I WERE BULLISH:
ADBE ($48.40) Sell Sept 47/50 Risk Reversal for .05 credit (sell put and buy call)
-Sell 1 Sept 47 Put at .60
-Buy 1 Sept 50 Call for .55
Break-Even on Sept Expiration:
Profits: If the stock is btwn 47 and 50 make .05 credit received for structure, above 50 have unlimited profits
Losses: below 47 have losses of stock, but almost 3% lower than current levels
Trade Rationale: This trade offers an almost 6% range (3% higher and 3% lower) from the spot price where nothing really happens, bu offers reasonable leverage to an out-sized move to the upside.
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Original Post Sept 10th, 2013: $ADBE Q3 Earnings Preview
Event: ADBE reports their fiscal Q3 earnings on September 17th after the close. The options market is implying about a 4.5% one day move, which is slightly below the 4 qtr avg of about 5%, but in line with the 8 qtr avg of about 4.5%.
Sentiment: Wall Street analysts are quite mixed on the stock, with 14 Buys, 11 Holds and 2 Sells, with an average 12 month price target of around $50.50. Short interest is around a 5 year low, at only 1% of float.
Options Open Interest: Open interest is evenly split between calls and puts, and the volume over the last month has been very limited (less than 1k options per day in either puts or calls). The largest near term open interest is the Sept 48 calls (nearly 2k), and the Oct 45 calls (4450) and Oct 45 puts (2402).
Price Action / Technicals: ADBE’s monthly chart shows a stock that is revisiting the 40-50 area for the 3rd time since the year 2000:
[caption id="attachment_30076" align="alignnone" width="600"]
Monthly chart of ADBE, red line at $48.49, courtesy of Bloomberg[/caption]
The key level in the near term is the $48.49 level that was the high back in 2007. ADBE briefly broke above that level on July 12th, but was unable to hold above there throughout July. The stock has rallied back to near that resistance area to start September, and a clean break to new all-time highs would be a very positive technical development. Otherwise, important support is in the 43-45 area, where buyers are likely to get interested. [private]
Fundamentals: Investors have greeted ADBE’s transition to a Software-as-a-Service Model with optimism. While the stock’s EPS has declined from 2.35 in calendar year 2011 to a projected 1.46 for calendar year 2013, investors are clearly assigning a higher multiple on future earnings from ADBE given the shift in the business model.
In the most recent quarter, the company obtained about 35% of revenues from subscribers and support services, vs. closer to 20% in the same quarter in 2012. Revenues were actually down 10%, and costs were up a bit more than 10%, so earnings were only one third of what they were in the same quarter in 2012, but the scaleability of the subscription model is the main attraction. It’s not a fight to sell new product each quarter.
Having said all that, with the stock near all-time highs, this quarter sets up as a crucial pivot point with expectations elevated. ADBE is currently trading at around 30x the consensus 2014 earnings number, though analysts are modeling 30%+ earnings growth in the 2015-2017 period. But with the stock’s technical position, this quarter’s results are key.
Volatility: ADBE has been a much less volatile stock from a realized volatility perspective in the past month compared to its price action over the past year:
[caption id="attachment_30077" align="alignnone" width="600"]
30 day implied volatility (red) vs. 30 day realized volatility (blue), Courtesy of LiveVolPro[/caption]
Realized volatility hit its lowest level in the past year (including holidays), as ADBE has remained between 45 and 48 for most of the past 2 months. Implied volatility has risen ahead of the earnings report, but it is at a lower level than prior to 3 of the past 4 earnings reports. 1 month implied volatility will likely fall into the high teens after the report.
Trades: Stay tuned for our thoughts on potential trade structures that we’ll be posting ahead of next week’s event.