Finding an Edge with Boston Scientific

In an uncertain, if not difficult market environment, one should be avoiding the financial sector black hole and looking for income opportunities with an edge in a sector not burdened with debt. Here is an interesting one in the medical devices sector.

Boston Scientific Corporation (BSX) 8.18. Natick, MA based BSX develops medical devices and interventional medical specialty products. The company and Angiotech Pharma (ANPI) .37 filled an application for Premarket approval (PMA) with the FDA on February 5, 2009 for two TAXUS (Liberate Atom & long) drug-eluting coronary stents (DES) with a decision expected by year-end. PMA is the FDA process of scientific and regulatory review to evaluate the safety and effectiveness of Class III medical devices.

Last Friday, using our IVolatility.com ranker tool, we found BSX in the number 5 spot in the Top 5 based on IV Index Mean vs. 30 day Historical Volatility. With an Implied Volatility Index Mean of 88.07 and a current Historical Volatility of 49.23 the ratio is 1.79. With implied volatility being higher by a ratio of 1.79 over the stock’s Historical Volatility.

Look at this favorable and increasing positive volatility spread. The IV Index Mean is orange and the Historical Volatility is blue.

click to enlarge

A positive volatility spread is our short hand method of describing a volatility pattern. For example, a Type I Volatility pattern is one where there is a significant difference between the implied volatility and the historical volatility of the stock, which we call a positive volatility spread. What we are looking for is the relationship between HV and IV. When we make a suggestion we include the HV as a reference marker for comparison to the IVs of the spread legs. If the IV’s are higher than the HV then we would be looking to sell the IV, as it is relatively more expensive. Hence we would sell put or a covered call in an attempt to capture the pricing differential. We refer to this as the edge.

There is an important difference between the Implied Volatility and the Historical Volatility as they are measuring different things. If the Implied Volatility is consistently higher than the Historical Volatility there is a statistical advantage that we refer to a Positive Volatility Spread that provides an edge to the option seller.

After identifying the volatility spread we want to know if the implied volatilities are being bid higher by call buyers expecting some good news or by put buyers with long stock positions and are seeking downside protection. At Advanced Historical Data we discover that put volume increased significantly on February 17, 2009 from about 2,000 to over 15,000 contracts. While put open interest has exceeded call open interest for quite awhile the latest put buying appears to be responsible for bidding up the options implied volatility, creating the wide spread that we found with our ranker. At the end of the week the put/call ratio was a bearish 1.5. With this data we will look for some puts to sell.

With the current Historical Volatility of the stock at 49.23 consider this Calendar Put Spread income strategy.

Sell BSX Mar 7 ½ put BSXOU .50 IV 90.41 Delta .3193 Vega .0082

Buy BSX Aug 7 ½ put BSXTU 1.15 IV 68.21 Delta -.3316 Vega .0211

Debit .65 Position net delta -.0123 Net Vega .0129

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the debit Monday should be about .67 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change. If the stock price is higher the spread net debit will be less by about .01 per point since the delta is negative at -.0123. If the stock price is lower the spread will be more by about .01 per point since the delta is negative at -.0123.

The spread will reach its maximum value if the stock closes exactly at 7 ½ on the March expiration since the March will expire, but since we are still long the August we will next sell the April 7 ½ put.

Notice the net Vega, or the amount an option price changes per a one- percentage change in implied volatility, shown above at .0129. This means if implied volatility increases it will benefit the position. If implied volatility declines it will be detrimental. In the fundamental information above we see that a decision on their stent PMA application is not expected until year end. With a long August 7 ½ put we could have an opportunity to sell 7 ½ puts at least 4 more times before the August expiration and if implied volatility continues rising as indicated in the chart they could be sold for higher prices in the subsequent months. In addition, notice the difference between the implied volatility of the Mar 7 ½ put at 90.41 that we are selling and the August 7 ½ put at 68.21 that we are buying. This is a good edge and we hope it can be maintained in the subsequent months.

In the meanwhile, with a Historical Volatility at 49 the stock is not moving fast, and looking at a stock chart, it appears to have considerable support at 8 having tested this level multiple times since last October.

On the downside, there is risk if the stock rises too far too soon. In this instance we don’t think it is likely that stock will rise before they get nearer to the expected approval date. In the event the stock declines below 7 ½ on the March expiration there will be a management issue with respect to the assigned stock from the short put. In this event, we will want to sell stock short with a market on close order (MOC) just before the options expire on the last Friday in order to be flat the following Monday after the stock is assigned. The alternative would be to sell the long put, but we would be giving up the time value in the long put. A better solution is to keep the long put and sell another put creating another calendar put spread.

Since the position is long Vega, or the amount an option price changes per a one- percentage change in implied volatility, another risk is declining volatility as the long term put will decline in value more than the near term put. Again referring to the volatility chart above we think it is more likely that implied volatility will be increasing as the expected PMA approval date gets closer.

Although more complicated to explain and with more position management issues to consider a calendar spread such as this one that has the potential for 4 more spread opportunities and could be very rewarding.

Disclosure: No current open positions.

Comments

[Marcap:]

With over $24.4 Billion (Sep '08) in stated Goodwill and other Intangibles, the company has virtually no Shareholder Equity. In fact, quite the contrary..It has a Shareholder Deficit of $8.73 Billion (Sep '08), and therefore little if any true value.

In my opinion, Boston Scientific is company already knocking on Bankruptcy's door. As of Sep '08, its Total Liabilities were almost 3 times its Total Tangible Assets ($14.1 Billion in Total Liabilities vs only $5.4 Billion in Tangible Assets). And that should pretty much explain the sell-off by the company's insiders and directors over these past few months, which was to the tune of almost 65 Million shares (38.3%).

Feb 23 06:53 PM

[Pj568:]

They did recognize a 2.7B goodwill impairment during the 4th quarter but it seems like only a partial acknowledgement of their goodwill problem. Before their disasterous acquisition, they generated sales of $1.13 for each dollar of long term assets; post acquisition it is $.33 of sales per long term asset. To top it off, BSX still believes it was a great acquisition, or so they say in public. If they mismanage their limited working capital they will be seeking relief either in the courts or thru some really expensive/dilutive equity raising pretty darn quickly.

Feb 23 10:37 PM

[Marcap:]

I agree that they did recognize a $2.7B write-down to their stated Goodwill in this most recent quarter, but I hardly think that a mere 11% adjustment will make much difference in the overall scheme of things. This is a company which has fallen into a very deep financial hole that I do not expect it can easily climb out of, regardless of the consequences which put it there.

As for working capital management, I think it would take more than a genius to find a viable way out of a more than 2.3 to 1, Liabilities to Tangible Assets, situation. They have a shortfall of over $6B with no means it would appear to get it.

Also I really do not think that raising funds through equity is a viable option. After all, with a shareholder deficit, after writing off all its Balance Sheet fluff, of more than $6B, at what price could additional shares be brought to market? Obviously nowhere remotely close to their current $8.00+ trading price, if at all. I can quite easily see a $2-3 share by year's end, if not sooner.

On Feb 23 10:37 PM Pj568 wrote:

> They did recognize a 2.7B goodwill impairment during the 4th quarter
> but it seems like only a partial acknowledgement of their goodwill
> problem. Before their disasterous acquisition, they generated sales
> of $1.13 for each dollar of long term assets; post acquisition it
> is $.33 of sales per long term asset. To top it off, BSX still believes
> it was a great acquisition, or so they say in public. If they mismanage
> their limited working capital they will be seeking relief either
> in the courts or thru some really expensive/dilutive equity raising
> pretty darn quickly.

Feb 24 06:07 AM

[Pj568:]

Don't get me wrong, I think BSX is in serious trouble with no easy out. When I said management thinks it was a great acquisition, it was to show how deluded they are.

Feb 24 09:36 AM