Trades

Adobe’s Consolidation Sets Up an Earnings Catalyst

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While tech stocks have been in the news so much of late, one strong performer over the last several years has kind of gotten a backseat in coverage.

Adobe Systems (ADBE) is a cloud-based software giant with near monopolies on certain creative programs like its Photoshop and Illustrator. It was one of the first to dive into a cloud-based subscription service years ago to maximize its top market position.

So far, that’s been working out quite well. Here you can see the monstrous multi-year rally since it launched its Creative Cloud:

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Sales, mostly from subscriptions to these cloud-based programs, have more than doubled since 2015, leading to ever higher profits, which have more than quadrupled in that time.

The company is no young and upcoming business, with operations dating back to the early 1980s. But its more recent ascent as a leader in cloud technology and platforms has certainly made it a major player these days.

However, as you can see, investors have only just now begun to wonder if its rise was too great:

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After falling with the rest of the market at the end of last year, shares began their climb again over the first half of 2019. Now, we’re seeing serious profit-taking.

That clear consolidation over the last month presents us with a unique opportunity. And the timing of this trend makes it an ideal options play.

You see, the company announces its third-quarter earnings this week. Analysts expect its top line to rise 23% year-over-year and its bottom line to come in 14% higher. These are lofty predictions, but not out of the question.

Adobe has beaten estimates three out of the last four quarters. And it could again.

Its subscription-based cloud service offers steady and stairstep growth, as it precludes creatives from sticking with older versions. Unlike your phone or your computer, you can’t just wait for a new version of Photoshop or Premier Pro. Besides pirating older copies, you have to pay for a subscription. Piracy, by the way, is near-impossible with Adobe’s cloud security.

This lets the company frequently surprise to the upside, as more and more companies are forced to adopt the cloud each quarter. That includes everything from video editing to marketing firms. Its breadth of software offerings makes it nearly essential across the economy… giving it some resistance against the shifting global economic volatility we’ve seen.

This next quarter should offer another nice upside surprise, as previous ones have. This time, however, it coincides with a month-long consolidation of share price. That tight trading range since the start of August shows that a breakout is on the table.

Right now, ADBE is sitting right at its support level, which sellers haven’t been able to break through. While those longer-term shareholders have been taking profits, this hard floor creates a great second buying point.

This week’s earnings announcement should be the catalyst to pick those shares off the floor. Whether they climb back to their 52-week highs of around $312 doesn’t really matter, unless you are looking to pick up shares. Instead, we have a better way to profit from this event-driven rally.

A Strategy For Short Term Bulls

A bull call spread is a type of options trade that involves buying one call option on a stock you believe will swing upwards in the short term and selling a second call with a higher strike price. The premium received from the latter helps offset the cost of the former.

This presents the trader with a more conservative entry price, with lower risk. However, in exchange for lowering the cost of the trade – and therefore the amount at risk of it – the maximum profit potential of the overall trade is capped.

You can see how this looks here:

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Source: The Options Industry Council

For ADBE, that’s not a bad trade off at all. Sure, the stock is set to breakout to the upside after Tuesday’s earnings announcement. But after an eight-year nearly unbroken rally, the chance for a major move is unlikely. This play’s not going to double overnight… well, the stock won’t at least.

Despite this type of trade coming with a ceiling on potential profits, it is a high-enough one. With the recent consolidation, traders can lock in a great risk-to-reward balance… offering potential gains well over twice the risk.

Let’s look at a specific example to see just how much they can expect…

A Specific Trade on ADBE

Right now, a trader could buy an October 18 $280 ADBE call for $9.81 per share and sell an October 18 $285 call for $7.35 per share for a cost of $2.46. Since each call is worth 100 shares of ADBE, that’s a total entry cost of $246.

That $246 is also the total amount at risk. If shares remain, somehow, in this consolidation pattern – or even more unlikely… fall from here – that’d be the total loss.

However, if shares do jump from here following this week’s numbers, the trader would be looking at a great return.

To find that, take the difference in strike prices ($285 – $280 = $5), and subtract the cost ($5 – $2.46 = $2.54). Again, since each option is worth 100 shares, that’s a maximum profit potential of $254.

In other words, traders would be sitting on a solid 103.3% return on their risk in just over one month. That’s a chance to more than double their money on a small post-earnings bounce of the underlying stock. In fact, that’s a chance at a double even without shares climbing back to their recent highs.

This is a great opportunity for anyone who has been left out of Adobe’s incredible, near decade-long rally. While the company’s share price might have further to go with its ever-increasing financials, it’s unlikely to see another double anytime soon. But with this trade, that’s back on the table.

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