Adobe (ADBE)stock has traded between 460 and 500 for most of two months with Bollinger Bands that are starting to get fairly narrow.
ADBE stock is also showing a very low implied volatility reading. In fact, the current level of implied volatility (28%) is lower than what we have seen 96% of the time in the last 12 months.
That could mean it’s a good time to be a buyer of volatility in ADBE stock. We can do this through a strategy called a long straddle. A long straddle is constructed through buying an at-the-money call and an-at-the-money put.
Buying at-the-money options can be expensive. They will also suffer from time decay, meaning that they will lose a little bit of value with each day that passes if the stock doesn’t make a big move.
With a long straddle, the further out in time the trade is placed, the slower the time decay. But the options are more expensive and require more capital.
For long straddles, I usually go out about three to four months and then look to close the trade half way through if the profit target or stop loss have not been hit. This helps to minimize the time decay which gets more severe the closer the trade gets to expiration.
For ADBE stock, a long straddle could be placed by buying a June 18 490 strike call and put. The call was trading yesterday around $42.40 and the put around $38.50.
When we add the two together, the total cost of the trade would be around $80.90 per contract or $8,900.
This is the total amount of risk in the trade and the maximum that could be lost. The maximum loss would occur only with ADBE stock right at 490 at expiration.
ADBE Stock Long Straddle Has A Wide Range Of Profit
The break-even prices are calculated by taking the strike price plus and minus the cost of the straddle.
That gives us break-even prices of 409.10 and 570.90, but profits can be made with a smaller move if the move comes earlier in the trade.
For example, the estimated break-even prices at the end of February are 445 and 520.
Changes to implied volatility will have a big impact on this trade and the interim break-even prices, so it’s important to have a solid understanding of volatility before placing a trade like this.
The worst-case scenario with this ADBE long straddle would be a stable stock price which would see the call and put slowly lose value each day. For a long straddle, I usually set a stop loss at around 20% of capital at risk which would be around $1,780.
Adobe is due to report earnings toward the end of March, and implied volatility is likely to drop after that event.
It’s important to 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
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