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When searching the web one can find a never ending list of articles and write-ups focused on the latest and greatest biotech stocks. These articles usually fulfill their purpose of increasing the awareness of up and coming biotech companies but often times fail to follow through on investing strategies. Many investors, if they decide to invest, will simply just go long the stock in question and await the final verdict of success or failure. While this is a perfectly viable investing strategy, one should also consider another avenue and that is the use of options. Either by themselves or in conjunction with a long (or short) position, they can make a speculative biotech trade a much more dynamic and profitable venture. This article’s purpose is to introduce some possible option trades and how they might be used in certain popular biotech stocks. Not all will be suitable for every investor by any means. Some will be quite risky while others will fall well into the conservative side of the trade. In the end though, it is hoped that the information communicated will teach investors how to spot potential options trades for themselves and not have to depend upon others or fall victim to an insane market.

The Long Call

This option trade is by far the easiest of all but also one of the most risky. Investors are attracted to this trade as there is a limited risk but unlimited reward potential. Another reason why investors like this trade is that it is much cheaper to buy call options than it is to buy the corresponding number of shares of the actual stock. For the speculative biotech investor there needs to be a little analysis done before entering into such a trade. First, the investor needs to determine the correct time frame the call needs to be purchased. For example, if a major groundbreaking decision is going to be made in late December 2011 it would make little sense to be buying calls in July 2011, as no one is expecting any meaningful events to occur by then. Second, one would need to determine the correct strike price to purchase. For example, if a stock were to trade at $2 a share and after some in-depth analysis one feels the stock should trade up to $10 a share after positive events, it would make little sense to be buying calls at the $20 strike as they will expire worthless. Let’s look at a real world example.

Dendreon Corporation (NASDAQ:DNDN) was a much beloved speculative biotech stock that soared in value as a series of events fell into place for the company. The stock traded in the mid to high $30 level as DNDN seemed to be hitting on all cylinders. Then the company had a sharp drop in price as demand for their product just did not materialize as was suggested by management. Today the stock trades around $9 a share while the company attempts to drum up business and demand for their drug. If you have faith that they will be successful in their attempt and foresee the stock at a much higher price in the coming year then maybe the purchase of the long call is as viable option. Let’s look at an option chain and see where we could buy one.

In our example we could just buy 100 shares of DNDN for $900 but let’s buy 2 January 2012 $10 contract for $1.40 instead. What we are buying is the right to purchase 200 shares of DNDN for $10 at any point in time from the time of purchase to the expiration date of the third Friday of January 2012. For this right we are going to be paying $280 ($1.40 x 2 contracts). So here are some possible scenarios of how this trade might play out.

• DNDN $10 on January 2012 – This outcome turn into a losing position for us. The investment makes money if the price is over $10 so a closing at $10 means the calls expire worthless and we lose all our initial investment of $280. The bright side is that we are only out our initial investment and nothing more and the risks were known before the trade commenced. In this case we would have been better off just buying the 100 shares for $900 as we would be up $100 on the trade.

• DNDN $5.00 on January 2012 – This outcome is also a losing position for us. The investment makes money if the price is over $10 so a closing at $5 means the calls expire worthless and we lose all our initial investment of $280. The bright side is that we are only out our initial investment and nothing more. If we had bought 100 shares of stock instead then we would have been better off as we would have a $400 loss.

• DNDN $20.00 on January 2012 – This outcome is the option investor’s dream. With DNDN at $20 on expiration day the call option we bought is worth $10 a contract ($20 share price - $10 strike price). Our initial investment for each call was $1.40 and we have 2 of them so our profit is $1,720 ($20 share price - $10 strike price – $1.40 original cost) X 2 contracts). This is the power of the long call. In comparison, if we had just bought the 100 shares of stock our profit would have been $1,100 ($20 share price - $9 purchase price). So in this instance the long calls would have made the most for the investor and was cheaper than buying the stock itself.

See the chart below for a visual representation.

Synthetic Long

A synthetic long option trade is an even riskier trade than the long call. In this trade one still buys a long call but finances the deal by selling a put option. At this point let’s discuss selling a put. When selling a put, one is agreeing to purchase a specific amount of a certain stock, for a specific price, within a given time frame. In return, as the seller you are going to be compensated for the promise by being paid cash upfront when the deal is made. With that cash in hand you then buy the long calls. Basically you are financing the entire deal with no money out of pocket but most brokers will make sure you have enough margin or cash on hand just in case. This is a risky trade but if successful can be most rewarding. Let’s look at another real world example.

An up and coming speculative biotech is Keryx (NASDAQ:KERX) who is a biopharmaceutical company focused on the acquisition, development and commercialization of medically important pharmaceutical products for the treatment of life-threatening diseases, including cancer and renal disease. Keryx is trying to bring two drugs to the market but it is Perifosine that has the potential to make a big splash for the company. Let’s look at an option chain and see where we could place a synthetic long option play based upon the company’s upcoming events.

By January 2013 Perifosine’s studies should be coming to an end and if successful the share price might be much higher than today’s value. That being the case let’s sell 5 January 2013 $2.50 put contracts and try to get $1.40 for each making a total of $700 (5 contracts = 500 shares X $1.40) of cash received. Being this far out in time the bid and ask are going to be wide so it might take some time. With this cash we are then going to buy 5 January 2013 $5 calls for $1.40. Other than commissions, the transaction did not cost us a dime but we have taken on lots of risk though. Let’s see how it plays out with examples. Please note thought that if one sells puts they can be executed at any time and not just at expiration. In our examples thought we will hold till expiration.

• KERX $5.00 on January 2013– This outcome is a push and we break even in the trade. The puts sold at the $2.50 strike will expire worthless but so will the $5 calls. All we are out here is the commissions on the trade. In this case we would have been better off just buying the shares at today’s price of $3 a share as we would have had a $2 profit per share.

• KERX $2.50 on January 2013 – This outcome is also a push and we break even in the trade. The puts sold at the $2.50 strike will expire worthless but so will the $5 calls. All we are out here is the commissions on the trade. In this case we would not have been better off just buying the shares at today’s price of $3 a share as we would have had a $0.50 loss per share.

• KERX $1.00 on January 2013 – This outcome is the big loser for the trade. With KERX at $1 on expiration day the call options we bought are worthless but we will be buying the 500 shares of KERX for $2.50 share as stipulated by the puts we sold unless we exit the contracts early. The 500 shares at $2.50 is $1,250 but the shares trade at $1 so we can recoup $500 ($1 X 500shrs). If we sold those shares back it would be a total loss of $750 for the entire trade.

See the chart below for a visual representation.

Bull Call Spread

Another option trade that is a bit more complicated but less risky is the bull call spread. This trade starts out like our long call trade above except that at the same time we buy one call, we short another call at a higher strike to reduce the cost of the trade. The negative aspect of this trade is that we will cap our gains but the flip side of the coin is that we will reduce our costs to initiate the trade. Let’s see an example as it is easier to visualize. Let’s consider Biosante Pharmaceuticals (BPAX) which is developing Bio-T-Gel. This is a once-daily transdermal testosterone gel for the treatment of male low testosterone levels. With a market in the U.S. over $1.2 billion and a license to Teva Pharmaceuticals, the company is one of the top speculative choices for biotech investors. A NDA is pending with the FDA having a date of November 14, 2011. That being the case, here is the option chain.

As one can see, the call options are pretty active as we grow closer to the pending date with the FDA. After careful consideration let’s say you want to purchase a bull call spread in December 2011 and you want to buy the $2.50 call for $0.60 and sell the $3.50 call for $0.30. Let’s make it interesting and purchase 10 calls in total. So to buy 10 December 2011 $2.50 calls it will cost us $600 ($0.60 X 10calls = 1,000shrs). At the same time we sell 10 December 2011 $3.50 calls for $300 ($0.30 X 10 calls = 1,000). Our total costs will be $300 to enter the trade ($600-$300). Now here is what can happen.

• BPAX $1 on December 2011– This outcome is a big loser for the trade. The call sold at the $3.50 strike will expire worthless but so will the $2.50 calls we bought. Our total loss is the $300.

• BPAX $2.50 on December 2011– This outcome is also a big loser. The call sold at the $3.50 strike will expire worthless but so will the $2.50 calls we bought. Our total loss is the $300.

•BPAX $3.50 on December 2011- This outcome is as good as it is going to get for the trade. With BPAX at $3.50 on expiration day the $2.50 call options we bought are worth $1 ($3.50 pps - $2.50 call). The $3.50 calls we sold are going to expire worthless. Our net cost to enter the trade was $300 and the long calls are worth $1,000 (10 calls = 1,000shr X $1 per call) so our total profit is $700.

•BPAX $10 on December 2011- Once again, since we are short the $3.50 calls that is where our gains will be capped. BPAX could climb to $100 and it would not matter. The difference between the strikes we bought and sold is $1. Our out of pocket cost is $0.30 so our net profit is all but capped at $0.70. Since we have 10 calls that equal 1,000 share we have a $700 profit plain and simple.

See the chart below for a visual representation.

Long Put

Up to this point we have been reviewing how to use options to make money in the biotech world. Now let’s shift gears and see how to use options to protect gains one already has. There are a couple of ways to do it but the best is via the long protective put. If an investor buys a protective put, they are basically paying for insurance, plain and simple. The buyer is paying the seller a set amount of money so that the seller will be obligated to buy a specific number shares at a future date for a specific (strike) price. That concept is simple and easy to understand. If on the expiration date the price of the stock is above the strike price where the put is sold, then the put expires worthless and the seller gets to keep 100% of the funds that you paid him and does not have to buy the stock. If on the expiration date the price of the stock is below the strike price where the put is sold (and the option is not closed out by you, the buyer), then the put will be exercised and the seller of the put will be getting your share at the agreed upon price. Of course, as the buyer of the put you can execute the contract at any time before expiration if you so choose. Once again let’s see an example.

Let’s look at Oncothyreon Inc. (NASDAQ:ONTY) which currently has one major play on their hands with the drug Stimuvax. Stimuvax is a therapeutic vaccine designed to stimulate an individual's immune system to recognize cancer cells and control their growth in order to increase the survival of patients. ONTY has partnered with Merck KGaA of Darmstadt, Germany, who is developing Stimuvax under a license agreement. There are two Phase III trials of Stimuvax underway, and interim results are due by the end of this year. Back in 2009 ONTY was selling for less than $1 and I am sure many people who bought then are still holding shares today. With a closing price of around $6, they have netted a substantial profit already. The question is how to protect the profits as they await the results? One answer is to buy the put. Here is the option chain.

Speculative biotech stocks are volatile so option premiums are going to be high translating into expensive contracts. Our investor, buying shares at less than $1, has over $5 a share profit to protect. One option would be to buy the January 2012 $6 put for $1.80 or $180 per 100 share of ONTY they own. Is that expensive? Yes but here is the logic. If the results are outstanding and the stock soars to $10 then the increase in the stock price will more than make up for the cost of the put that will expire worthless. On the other hand, if the results totally fail and the stock price plummets to $2 a share, the put will kick in at $6 and protect most of the profits. In that case the put owner would receive $4.20 ($6 strike - $1.80 cost per contract) a share for the stock that is trading at $2 a share. On the surface it sounds terrible but just ask anyone long DNDN at $35 a share who woke up the next morning to find the shares trading at $12 if they wish they had puts.

Finally, after investors get a taste of options they want to start using them right away across all different biotech stocks. They are often disappointed though when they find out that lot of these stocks do not even have options. For example, consider the company AEterna Zentaris (NASDAQ:AEZS) which shares the same exposure to the drug Perifosine as KERX above. KERX has actively traded options while AEZS does not have any at all. Or consider the company Antares (AIS) who is a small pharmaceutical company with a business line that focuses on self injection technologies and topical gel-based products. At first glance one would assume they would surely have options because of their huge potential, but that is not the case as they have none at all. The key point here is to make sure you have actively traded options available before just diving into a trade hoping they will be there when you need them.

In conclusion, this article is just a taste of the world of options and how they might be used in the speculative biotech investing world. There is no way that just one article could cover the gambit of all the different combinations and styles of option trades that exist. Before trading options, one needs to understand all the risks and rules associated with the trade. What I hope is communicated though is that without options, the biotech investor can be place at a disadvantage as they are not equipped with all the tools they need to give them the best chance for success.

Source: Using Options In Speculative Biotech Investing