The price of Adobe (ADBE) stock has pulled back in recent weeks, with the $500 level providing strong support.
When a quality company has a minor pullback like this, I like to use a strategy called a diagonal put spread.
This option strategy is an advanced strategy because it utilizes options over different expiration periods and different strike prices.
The strategy involves selling an out-of-the-money put for a near term expiry and then buying a put for around the same price using a later expiry.
The idea with the trade is that the stock might fall a little bit more, but should stay above the short strike price.
Let’s look at an example using Adobe.
Adobe Diagonal Put Spread Example
The trade I’m looking at is selling an October 20 put with a strike price of $490 and buying a November 17 put with a strike price of $470.
As of Friday’s close, the October 21 put could be sold for around $6.60 and the November 17 put could be bought for $7.75.
The net cost on the trade would be $115 and that is the most the trade could lose on the upside.
The risk on the trade is on the downside with a potential maximum loss of $2,115. This is calculated by taking the difference in the spread (20) multiplied by 100 and adding in the cost of the trade (115).
The maximum potential gain is around $780 which would occur if ADBE closes right at $490 on October 20.
The trade has a nice profit zone in between $480 and $540.
Aiming for a return of around 10-15% makes sense and I would set a similar stop loss.
The worst-case scenario is a sharp drop in ADBE stock early in the trade. For this reason, if the stock drops below $490 in the next few days, I would also consider closing the trade early to minimize losses.
The initial trade set up has a delta of 5 meaning the position is roughly equivalent to owning 5 shares of ADBE stock. Note that this delta number can change significantly as the stock starts to move.
Below is the payoff graph with the blue line representing the profit or loss at expiration and the purple line being the trade as of today.
This is how the trade could look in around two weeks time.
So, provided ADBE stock stays above $490 in the next two weeks, the trade should be ok. As the trade requires the stock to not drop too much, this would not be an appropriate strategy for bearish traders.
Adobe Company Details
The Barchart Technical Opinion rating is a 56% Buy with a weakening short term outlook on maintaining the current direction. Long term indicators fully support a continuation of the trend.
Adobe Inc. is one of the largest software companies in the world. Adobe picks up licensing fees from customers, which form the bulk of its revenue. The company also offers technical support and education, which account for the balance. The company operates through three segments. The Digital Media solutions segment enables small businesses and enterprises to create highly compelling content, deliver it across diverse media through smartphones, tablets, e-readers, and other devices, and then optimize it through systematic targeting and measurement. Within Digital Media, the two major components of revenue are the Creative family of products and Document Services products. The target customers are traditional content creators, web application developers, digital media professionals and user interface designers/developers, writers, videographers and photographers.
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.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
