A little over a month ago we previewed ADBE earnings and offered a defined risk stock alternative to play for a breakout. Here was the original trade idea, from March 16th:
And what about those looking to buy some of these high-performing stocks but terrified of this entry? Defined risk is possible:
Stock Alternative/ Replacement
In Lieu of 100 shares of ADBE ($122.10), buy the April 120/130/140 call fly for 3.00
- Buy 1 April 120 call for 4.70
- Sell 2 April 130 calls at .90 (1.80 total)
- Buy 1 April 140 call for .10
The stock popped on the results and the next day we said to keep 130 as a target and be patient. When the stock got to 130 we wrote this update on April 7th:
The stock is now 130 and the original trade idea is now worth 7 or more than a double. Since it still has $3 of extrinsic premium (more can be made as the short 2x 130 calls decay) there’s no rush to take profits. But if the profits are enough as is that’s another story. For those that want to get closer to fair value, stops $3 below and $3 higher than the 130 strike makes sense, profits would not be that different than current if the stock made a move away from strike until outside that band.
I want to dive a little deeper into this trade management philosophy because it’s an important skill for letting a winner run. In this case the stock made a move to our target price. The trade idea had nice profits at that point. But because the stock was treading water near our target price we could be patient and let more profits roll in on the short premium of the 130 strike. And that’s exactly what happened. The stock is now 131.30 and the trade idea is worth 8.60. So the stock moved away from the strike but it still gained (and gained more than the move itself).
In that update, we identified stops $3 lower and $3 higher than where the stock was trading. Why 127 and 133 as stops? At the time of that update, the trade was worth $7 mark to market. That means that as long as the stock was within the range of 127 and 133 on expiration day (today) it would be worth more than 7. Essentially, we had a $6 dollar range of profitability, and very little risk, even on a move away from the 130 strike unless that range became threatened. The delta of the trade when the stock was 130 was essentially zero. A move to 127 or 133 that triggered the stop would still have left us with a $7 trade mark to market, or close to it. The only risk was gap risk. In other words, the reward of further gains far outweighed the risk of losing profits and that’s exactly how things played out.
So now, with only a few hours left until expiration the trade can be closed at 8.60 by selling the April 120 call, and buying to close the two 130 calls. The 140 calls don’t need to be closed because they are worthless, saving a small bit on commissions.
I wrote about extrinsic/intrinsic premium the other day here: Volatile Compounds – Option Premium into/out of Earnings
This is a case where understanding that relationship allows for patience on the risk/reward left in a trade. This lesson can be applied to all of your trade management, on both long and short premium trades