Earlier, Dan previewed Adobe’s (ADBE) Q1 earnings due after the bell. Like I did last week with ORCL and ratio spreads versus long stock, I want to use ADBE’s earnings event as an educational look into another earnings strategy, this time without an existing long position.
You’ll see us mention calendar spreads from time to time. That is a trade where you sell a near term option and buy the same strike farther out. You’ll also see us use this trade structure for different purposes. Often we’ll sell a front month option during a period where we expect few fireworks out of the stock, and use those proceeds to buy a farther out month where we can isolate an event, like an earnings or a product announcement. From a strict implied volatility standpoint you would want to sell higher vol months and buy lower vol months. But in the example of wanting to own the event month, you often are willing to sell lower implied volatility in the front month at a lower volatility than what you own. But that volatility is for a reason in the event month, and in a lot of cases it stays bid (or increases) as that front month decays, and protects you from decay until the event month arrives.
The other way we’ll sometimes use calendars is the opposite set-up, where an event is at hand, and we want to sell that event, and own farther out options. And that’s the set-up we see in ADBE today. The March options (expiring tomorrow) are implying about a 5% move in either direction. That translates to about 120 vol in March. In comparison, April vol is about 32.
Now here’s a caveat. The implied volatility of options expiring tomorrow, with an event tonight is definitely apples to oranges when comparing to outer months. BUT, if those outer months aren’t expensive in historical terms, it sets up for a really nice directional trade opportunity where your risk is defined.
A 5.5% implied move on an 89 dollar stock essentially means that ADBE’s move in either direction will be about $5. There’s also the chance is doesn’t move much at all, and then there’s the chance it moves alot more than $5. In general, the chances of the implied move or less is much higher than the chance of a real surprise outside the implied move. But there’s a catch, if the trade is not defined, the risk of surprisingly big move is asymmetrical in what you can lose. That’s why you don;t see us just recommending selling the at-the-money straddle into every event. Mathematically you’d probably make good money over time. But the times when a VRX happens, well, not many people have that kind of money to stay with the strategy, not even Bill Ackman.
So what’s the next thing we look at? What are we buying in the outer month and how does that compare historically? In ADBE’s case, April at 30 IV doesn’t look that high at all:
In this chart from LiveVol Pro you see 30 day Implied Vol (red) and 360 day implied vol (pink). The historical average implied vol is about 27, so April vol around 30 isn’t too bad, especially considering what you can sell in March to finance it.
So ADBE, a 5 dollar move in either direction, 130+ vol in March and 32 vol in April. So What’s the Trade?
Buy the ADBE (89) March/April 95 call calendar for .50
- Sell 1 March 95 call at .45
- Buy 1 April 95 call for .95
Buy the ADBE (89) March/April 82.5 put calendar for .65
- Sell 1 March 82.5 put at .55
- Buy 1 April 82.5 put for 1.20
In both these cases you are set up for a move just outside the implied move with a sale of the front month options at a very high volatility, financing a put of a call in April close to the historical mean in volatility and being set-up for the next month for a breakout ot new highs or a break down to recent lows in a very low amount/ defined risk trade.