Anatomy of a Trade – $ADBE Clone Tool

by CC December 23, 2015 12:23 pm • Commentary

On December 10th Adobe (ADBE) reported Q4 earnings that beat estimates with revenues inline. The stock made a new high in the days that followed before retreating a little. It is now making a move back towards its highs. Because of the set-up into the event (stock near highs) and high sentiment we detailed a few defensive options positions. One was simply a hedge vs long stock and the other a stock alternative/replacement for those that were long or thinking of getting long near the highs. I want to review the stock alternative, which is a January expiration because it’s interesting in that it was a slightly unconventional structure. Here was the original trade idea and rationale:

Stock Alternative/ Replacement in lieu of 100 shares of stock:

Buy the ADBE (90) January 87.5/97.5/105 (unbalanced) call fly for 3.20
  • buy 1 Jan 87.5 call for 4.90
  • sell 2 Jan 97.5 calls at .95 (1.90 total)
  • buy 1 Jan 105  call for .20

Rationale – This trade defines risk to 3.20 in ADBE and starts in the money so it minimizes risk of being long premium (its breakeven is just .70 higher at 90.70). Profits are like stock (on January expiration) above 90.70 and with a max gain of up to 6.80 at 97.50. Gains trail off above that.

This trade risks just 3.5% of the underlying with the chance to make up to 7.5% of the underlying on a move towards 97.50 in January. We like the idea of defining risk as we think just being long stock near highs is too risky given the potential downside vs upside moves. This trade reflects that opinion.

This trade is working well as the trade is now worth about 5.60 with the stock at 94.15. It’s still quite bullish with a delta of +35. So ideally we’d see ADBE work it’s way back to new highs in the next month. A close on January expiration at 97.50 is ideal as the trade would be worth $10.

Since the butterfly is unbalanced (the long strike to the upside is 7.50 away from the mid point rather than the $10 distance between the lower and mid strike) it’s even more bullish than a balanced strike in the money fly would be at this point. That means it is much closer to being long stock at this point as profits will trail off less above 97.50 than with a standard butterfly. That’s important for trade management as you’ll want to keep a mental stop tighter on the downside than on the upside. Intrinsically this trade is worth 6.65 with the stock at 94.15 so there’s not a ton of decay at this point.

Bottom line, the best way to think about this is still as a stock alternative, but now risking 5.60 (its current value) to make another 4.40 if the stock works its way to 97.50 in the next few weeks. So patience is in order but only to the upside. If the stock fails here and starts working its way lower it makes sense to take the profits and possibly re position into the New Year. We’ll update the trade idea if that happens, and on the upside we’ll update when we feel the risk reward of the profits vs potential loss of profits means it’s time for a roll into a new position.