Anatomy of a Trade – $ADBE Stock Alternative

by CC April 14, 2015 2:27 pm • Education

On of our favorite structures for long stock alternatives is an in the money call fly. The reasoning is you are often able to effectively own the stock at or below where it is trading while defining your risk in case your long entry is wrong. We highlighted ADBE a few weeks ago and demonstrated a hypothetical long. Here was that trade and rationale:

We actually like a alternative here in lieu of stock. This is for those that would like to be long the stock here but with defined risk or simply those that want to replace their existing stock with defined risk:

Hypothetical Trade – ADBE ($74.25) Buy the May 72.50/77.50/82.50 call fly for 1.65

Rationale – This is essentially buying ADBE stock at 74.15 with risk of only 1.65 to the downside. The only thing given up is any move higher above 77.50 in the next month and a half and profits start to trail off. The maximum potential gain is 3.35 at 77.50 in the stock. Given that fact that earnings are after May expiration this works as a nice stock alternative.

The stock is slightly higher now so it’s a good time to check in on that trade and see how it’s doing. The key to a trade like this is that it doesn’t act as an exact stock alternative until expiration. What you are giving up in near term profits is the cost of having defined risk.

With the stock 75.85 today the fly is now worth about 2.15. So that’s 50c in gains on the fly vs. 1.60 in the stock. So that’s good but obviously not as good as just being long the stock. The issue here is this trade does not expire until May 15th. So the “cost” of defining your risk so far has been about a dollar. However, the gains will be one to one (plus 10c) if the stock were to close here on May expiration. And the risk is still defined. If the market tanked or company specific news hit and sent shares lower the risk is still only 2.15 total (and 1.65 on a cost basis).

Additionally since this trade is still only about +12 deltas the immediate risk of smaller selloffs is also lessened. In fact, the stock could be back to the entry point tomorrow and this trade would still be profitable, unlike stock.

So there are tradeoffs in the near term with any multi-legged structure as its full profit potential isn’t realized until expiration. But those trade-offs are also what makes them preferable to begin with. Namely, defining risk.