Thursday, December 11, 2014

ADBE: Volatility play

Update 12/17/2014: ADBE gapped up immediately after earnings were announced, leaving me on the wrong side of the trade. It fell back for two subsequent days but rose again today, although remaining below the post-earnings peak. I've closed the position to avoid exercise when it expires at the end of the week.

Click on chart to enlarge.
ADBE 5 days 30-minute bars, 12/10/2014 - 12/17/2014
Shares rose by 4.4% over the six-day lifespan of the position, for a 266.9% annual rate. The options produced a negative 89.39% loss on debit, for a -5,438.1% annual rate.

Clearly, I got the direction of the reaction wrong. I had a bear position; the stock moved in a  bull direction. My judgement of the direction matched the chart, so I followed my rules and preferences properly.

Note that the high of the post-earnings reaction remained within the 95%, two standard deviation range, so it counts as a plain vanilla swan, not a black swan by any means.

The software company Adobe Systems Inc.a (ADBE), headquartered in San Jose, California, is best known for its ubiquitous reader that respects document formatting, its Photoshop image-editing program and the Flash video platform. The software line in its portfolio includes much more besides. Adobe publishes earnings after the closing bell today, Dec. 11. [ADBE in Wikipedia]


Implied volatility stands at 36%, in the 98th percentile of the rise that ended Oct. 15. It has declined slightly since hitting that peak.

The one standard deviation range, encompassing 68.2% of trades of the next week, implies a potential gain or loss of 5%, and the two standard deviation range, covering 95%, a 9.9% gain or loss.

Ranges implied by options and the chart
WeekSD1 68.2%SD2 95%Chart
Implied volatility 1 and 2 standard deviations; chart support and resistance

The chart direction is bearish, coming off a significant reversal at $74.10 on Nov. 28. The marked stair step  nature of the decline has produced a narrow chart range -- a move above $71.0 would break the downtrend; a move below $69.74 would confirm it.

Click on chart to enlarge.
ADBE 15 days 15-minute bars

The Trade

ADBE has no Weeklys in its options inventory, leaving it at a choice between the Dec. 19 and Jan. 15 monthly issues. The December issue is preferable because it carries less time risk, and if I can make it work, that will be my choice.

Bear call spread, short the $72.5 calls and long the $75 calls
sold for a credit and expiring Dec. 19
Probability of expiring out-of-the-money

The risk/reward is 2.6:1, well below my maximum risk of 4:1.

The position covers all of the chart range but leaves 18% of the one standard deviation range and 34% of the two standard deviation range uncovered.

Decision for My Account

There's nothing to dislike about this chart, the risks or the probabilities. I've opened a position structured as a bear call spread, as described above. It was an easy fill; I only had to lower my ask by a penny to attract a buyer.

-- Tim Bovee, Portland, Oregon, Dec. 11, 2014


My volatility trading rules can be read here. For a discussion of the rationale behind the rules, see my essay, "Rules for very short term trades".

From time to time 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.

My method of scoring price and volatility responses to earnings, used in the "Chart" section, is the simplest imaginable. Looking at the four most recent earnings announcements, I give one point for a rising price or rising volatility in the week after the announcement, subtract a point to a falling price or volatility, and give a zero if the response is  sideways movement. I then add the four quarters together to produce separate scores for price and volatility, and then add the two to produce a combined score. 

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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