I remain keen on exploring options that allow me to participate with controlled downside. So Adobe, a leader in the past week's upward moves, may be a good one to explore right now. This column looks at a customized version of the butterfly option trade in Adobe stock.
The market has strengthened its confirmed uptrend for several weeks. With Wednesday's FOMC decision on holding interest rates steady, the major indexes continue upward with improved market breadth. Also, stocks in long bases finally are beginning to break out and join the party.
Adobe, the digital media and marketing software firm, reported a solid beat but issued mixed guidance. The earnings release made a point of emphasizing its exposure to and use of AI (artificial intelligence) in its future development.
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This company stands at the head of leadership in design, imaging and publishing software.
Also, its desktop software industry group shows a high level of relative strength among the 197 industries tracked each day by IBD.
Adobe Stock Today: Setting Up A Custom Butterfly
We have several tools for taking advantage of the current conditions in the option toolbox. However, the custom butterfly positions me for significant upside while reducing my cost to engage.
The duration for this position in Adobe stock is very short, as the options involved expire next Friday on June 23. The goal in this trade? Participate in upward motion with limited risk as prices continue to extend sharply.
Here are the details:
- Buy to open 1 ADBE 23 Jun weekly 505 call.
- Sell to open 3 ADBE 23 Jun weekly 535 calls.
- Buy to open 2 ADBE 23 Jun weekly 560 calls.
This butterfly formation allows us to take advantage of upside pressure in the next week, and then use the proceeds from the call credit spreads to pay for the in-the-money call strike.
Total debit spent comes out to roughly $1.05 per spread, based on Thursday's price action. This trade, as of Thursday, carried a total risk of $1.05. The break-even price (before commissions) is $506.05.
Calculate the maximum return by taking the 30-point difference between the call strikes of 535 and 505, less the premium paid of $1.05, which equals $28.95. One option contract involves 100 shares, so the total profit could hit $2,895.
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Defending The Trade
Stock hunting using fundamental and price strength within the IBD method of stock selection is where I firmly plant myself given the current economic backdrop. I use technical analysis to find ideal buying opportunities in conjunction with the tools for strength seen in IBD. Adobe stock checks all of the boxes for strength continuation.
This spread holds long call spreads and short call spreads that allow me to enter as the price rallies with a small debit of $1.05 at the 505 strike.
The flip side: We have a bounded reward, as it cannot deliver more than $28.95 per set of contracts.
Managing This Trade In Adobe Stock
Make sure you identify key chart levels.
For instance, the weekly near-term resistance zone sits near 535 and the spread formation will begin to erode into negative returns if prices move above $542.50. Price action support in Adobe stock sits near 474.
What could happen in this trade in Adobe stock? Consider these four possibilities. One, Adobe stock moves higher and sits over 505, but it does not rise above 535 into expiration on June 23. So I make the maximum amount of $28.95.
Two, Adobe stock moves lower. I lose 50% of the price of the premium of $1.05, and therefore exit the trade.
Three, ADBE stays within the region between 505 and 535. The premium doubles in price, at which point I will cut my position in half and then trail the rest up into the possibility of the premium tripling. Then we hit rarefied air and should manage the trade much more tightly.
Four, set an alert for the prices on the edge (near 535) and if it triggers, consider taking profit quickly as the expiration is so close. As with all trades, consider what you like about holding the position in the first place and consider your risk carefully.
Anne-Marie Baiynd is a 20-year veteran trader of stocks, options and futures and is the author of "The Trading Book: A Complete Solution to Mastering Technical Systems and Trading Psychology." She holds no positions in the investments she writes about for IBD. You can find her on Twitter and Stocktwits at @AnneMarieTrades
