Wednesday, May 7, 2014

ADBE: A curious case

Update 5/27/2014: Due to a trading error, ADBE never made it to the Roll Shelf, so I've sold them and calculated my losses, which are substantial. ADBE has moved above the 20-day price channel. 

During the 20 days I held a bear position in ADBE, the price rose by 11.9%, or 217.7% annualized.

My options produced a 73.6% loss on risk, and a 168.4% loss on the debits.

Moral of the story: Don't make trading mistakes. Ouch!

Update 5/13/2014: ADBE, a bear play, moved above its stop/loss point on May 12 and confirmed it the next day. I've sold my position and moved ADBE to the Roll Shelf. I'll calculate results once the roll series has ended.

Update 5/7/2014: I've opened a bear position in ADBE, structuring it as vertical spreads built from puts expiring in June and sold for credit, short the $60 strike and long the $62.50. Leverage is 4.3:1.

Adobe Systems Inc. (ADBE) peaked in late February and as of today's open had dropped 16.2% off of that high. The decline pushed ADBE below its 20-day price channel, sending a bear signal that was confirmed today as the stock traded still lower.

The magnitude of the drop suggests that February really did mark the end of the rise that began in November 2011, which carried the price up by 120%. ADBE is in the midst of a significant correction, but once it ends, the price will push upward to new highs.

And yet there the Greek chorus of analysts, intoning a bullish hymn of praise, set in counterpart to financials that produce a disinterested "Meh".

A curious case, indeed.

The Chart

The Feb. 28 peak of $71.11 marked the end of  wave 3{+2}, which began Nov. 25, 2011 from $25.72. That wave in turn is the middle leg of wave 1 {+3}, which began Aug. 11, 2011 from $22.67.

The decline so far has retraced the wave 3 {+2} rise by the Fibonacci 23.6% level, a fairly shallow yet not uncommon correction. The next major stopping points on the Fibonacci retracement ladder are 38.2% at $53.75, 50% at $48.39 and 61.8% at $43.03.

Click on chart to enlarge.
ADBE 3 years 3-day bars (left), 90 days 2-hour bars (right)
In any case, the correction is consistent with Feb. 28 marking the end of wave 3 {+2}. An alternative analysis would label the rise as a correction within a continuing wave 5 of 5 {+1} to the upside, but that retracement today exceeded 100%. The decline below $57.32, the start of wave 5 to the upside on Feb. 3, discredited that alternative count.

ADBE's chart is bearish, with a great deal of potential to the downside. However, there is nothing that requires the price to go still lower. Under the Elliott wave rules, it would be possible to count the correction as complete. However, I think it's unlikely.

Options are pricing in confidence that 68.2% of trades will fall between $52.44 and $63.58 over the next month, for a potential gain or loss of 9.6%, and between $55.33 and $60.69 over the next week. The monthly range appears on the chart as blue lines labeled "Range high" and "Range low".

The range suggests that it would take only 38.2% retracement to cover more than two thirds of trades over the next month.

Odds and Yields

ADBE has completed one bear signal since the downtrend began on Feb. 28. It was successful, but with a relatively small yield. The profit was 1.4% over 19 days.

The Company

Adobe Systems, headquartered in San Jose, California, is perhaps best known for its free Adobe Reader software, which has become a global standard for distributing documents that mimic the printed page.

Adobe's line includes a range of editing, publishing and marketing tools, including the ubiquitous image-editing program Photoshop and the work-from-anywhere software service Adobe Creative Cloud.

Creative Cloud, in fact, is Adobe's most productive undertaking, accounting for 55% of its market cap.

Analysts are optimistic about Adobe's future performance, collectively coming down with a 33% enthusiasm rating.

The trailing numbers, however, fall short of growth-stock territory. Return on equity is only 6%, with long-term debt amounting to 14% of equity. My profile of a growth stock places return on equity at 20% and more, with debt under 10% of equity.

Earnings have been steady for most of the last three years. They took a sharp drop in the 1st quarter of 2013 and have trended sideways thereafter. ADBE has surprised to the upside 10 times in the last three years, and twice to the downside, most recently in the 3rd quarter of 2013.

The earnings yield is 0.983%, compared to 2.59% on 10-year Treasury notes. The earnings yield is lower than 91% of other software and programming companies.

The company pays no dividend.

The stock sells 108 times earnings, and also at a high premium to sales. It takes $7.31 in shares to control a dollar in sales.

Institutions own 88% of shares.

Adobe next publishes earnings on June 17.

Liquidity and Volatility

ADBE on average trades 3.5 million shares a day and supports a moderate selection of option strike prices spaced $2.50 apart near the money, with open interest running mainly to three figures.

The front-month at-the-money bid/ask spread on puts is 3.3%, compared to 0.5% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 33%, compared to 14% for the S&P 500. ADBE's implied volatility stands in the 82nd percentile, suggesting that short options spreads, sold for credit, have the best chance of success.

Implied volatility is 25% higher than historical volatility.

The conventional wisdom is that rising volatility implies falling prices, so that level of volatility is a bearish sign.

Contracts today are heavily skewed toward puts, which are running at nearly triple their five-day average volume. Calls are running at less than half the five-day average volume.

Decision for My Account

The chart is without question bearish under the Elliott wave rules, and has been since late February. The company's financials are nothing awful but also nothing to cheer about. Yet, analysts and the Zacks rating on balance come down as bullish.

When I see such an anomalous situation, I tend to scratch my head and mutter, "What do they  know that I don't". But then I straighten my back and go with my own judgment. Based on the chart and the high volatility, I come down on the bearish side in assessing ADBE.

I intend to open a bear position in ADBE under my shorter-term rules if downward momentum continues into the half hour before the closing bell. If momentum falters, then I'll add ADBE to my Watchlist for later consideration.


My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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