Adobe is due to report earnings next Wednesday after the closing bell. Right now, the options market is pricing in an expected range of a 6.6% move in either direction. Today we'll look at how to set our strikes on an option trade for Adobe stock.
Adobe Stock Earnings On Tap
First, it's a good idea to understand the recent history of a stock around earnings. Adobe stock stayed above the lower expected range following five of the last six earnings announcements.
With this knowledge, let's analyze how we can structure an option trade that fits the view that:
- We think ADBE stock will stay within the expected range.
- The response to the earnings report is likely to be positive.
To that end we can use a bull put spread on Adobe stock. With the bull put spread, you sell a put at the lower limit of where you think the stock will go and simultaneously buy a put at a lower strike. That acts as protection in case you're wrong and defines your risk.
Taking the at-the-money put and call for the Dec. 15 expiration, we can see that the expected range is around 40 points, or 6.6% of the current stock price of 605.
Now that we know the expected range, let's find a bull put spread for Adobe stock that has the short strike roughly 40 points below that price.
Setting Up The Trade
Selling the 565-strike put and buying the 560 put, both at the Dec. 15 expiration, creates the bull put spread. The 565 short put as a lower limit for the expected move dovetails nicely with the 50-day moving average line at around that level.
This spread is trading for around 87 cents this morning.
That means the trader receives $87 in option premium and has a maximum risk of $413. You calculate the maximum risk by taking the difference in the strikes and subtracting the option premium received.
It represents a 21% return on risk between now and Dec. 15 if Adobe stock remains above 565.
Knowing The Risks
If ADBE closes below 560 on the expiration date, the trade loses the full $413.
The break-even point for the bull put spread is 564.13, which is calculated as 565 less the 87-cent option premium per contract.
There is little room for adjustment with short-term trades such as this held over earnings.
A 21% return in a few days would be nice, but the possibility of losing 100% is also very real. As such, this style of trade is only for traders with a high risk tolerance, and you'll need to size the position accordingly.
According to IBD Stock Checkup, Adobe stock ranks No. 2 in its group and recently showed a Composite Rating of 98, an EPS Rating of 96 and a Relative Strength Rating of 96.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
