Adobe is under pressure today after its earnings report yesterday. It's already down 14% Friday and could see an additional 20% evaporate before the next earnings report. This long put butterfly spread assumes Adobe stock prices will fall over the next couple of months but may eventually find support at 400.
The Backdrop Of Adobe Stock Earnings
An expectation for Adobe stock weakness isn't just about Adobe.
Hot inflation numbers this week are giving the traders waiting for a rate reduction some angst. The market is showing us that through some sector rotation.
On top of that, investors have been unforgiving with less-than-stellar earnings reports or weakness on forward guidance. Though longer-term traders are still in the throes of a "buy the dip" mindset, what we can see is that the dips might be deeper and more patience will be required to endure weaker price action.
With Adobe stock, weaker forward guidance was certainly an issue. Maybe a lack of AI commitment was perceived as well. But the $25 billion buyback plan wasn't enough to stave off traders heading for the fire escape.
Price action is near July 2022 lows, and with traders nervous in general we are likely to see the stock test 2023 breakout levels of 400 before the next earnings report.
Setting Up The Trade
The long put butterfly spread is a neutral to bearish position. Our setup here estimates that prices will fall over the next couple of months before settling around 400. This is where a large amount of accumulation occurred.
Construct the long put butterfly spread for Adobe in this manner:
- Buy to open 1 ADBE June 21-expiration put with a 440 strike price.
- Sell to open 2 ADBE June 21-expiration put with a 400 strike price.
- Buy to open 1 ADBE June 21-expiration put with a 360 strike price.
Total debit is roughly 4.25 per spread, based on recent trading. That means the break-even cost for the trade in ADBE stock is 435.75 — the price of the higher long-option strike minus the cost of the option. There is another break-even price on the lower side, but my expectation is to book profit before it gets to that level. I don't want to see a strong profit turn to a loss.
Know Your Exit In Advance
- Sell the entire butterfly spread once it carries an acceptable profit – 50% to 100% for me, but price behavior will determine the move. The example above suggests an average price of 8.50 or better to consider taking profit.
- Sell the entire butterfly spread once it hits your loss threshold as determined by personal risk. That's -50% for me. The loss threshold price here is near 2.10 for my risk.
- Sell the entire butterfly spread when prices test the middle strike.
- Sell the long put spread when the middle strike tests, and let the short put spread erode to expire worthless. A quick warning: This strategy requires increased skill level and attention as it opens the trader to additional risk.
Defending The Trade In Adobe Stock
Stock-hunting using fundamental and price strength within the IBD methodology is where I firmly plant myself under the current economic backdrop. I use technical analysis to find ideal buying opportunities in conjunction with the tools for strength seen on IBD.
The goal of taking the butterfly trade is to gain exposure to profit but to significantly limit loss if we are incorrect.
Options sellers are positioned to win in two ways. Either Adobe stock does nothing, or the stock moves within the ranges. We can use this concept to minimize the risk of market exposure. In this case, we are option buyers. So we are looking for prices to move south to gain maximum available returns.
Key Chart Levels
The monthly support zone sits near 400. Just draw a line there at the month of May and extend it to the left and you'll see it.
If we see some sharp dips early in the trade timeline, our profit will be less extreme. But if the moves to our key support area of $400 happen near the expiration, our profit will appear significantly and swiftly due to the nature of the butterfly.
Here are scenarios to consider for the long put butterfly on Adobe:
- Adobe dips lower but does not break the 440 price after a week of testing the congestion level here. If it bounces and shows itself as favorable to the traders looking for a buy zone, we should consider this as a signal to potentially leave the trade.
- If the stock grinds lower much earlier in the cycle and the option position increases in value (but less than 30%), we could certainly choose to sell the entire position and quickly take the gains, freeing up more capital to trade.
- If ADBE grinds lower and tests or breaches the $400 price but begins to hold, this suggests traders are willing to put a floor in the price. This is ideal if it occurs in the near term and into the June expiration strike. The next earnings report on Adobe stock will probably be around June 13. We should consider closing this trade prior to that event.
As with all trades, consider what you like about holding the position in the first place and consider your risk carefully.
Be patient and allow price action to move around a range of your stops.
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
