I have always been attracted to stocks that could potentially move significantly higher based upon a positive event but would move down minimally on a contrary outcome. Stocks that have discounted the "absence of positive news" can be quite appealing. After all, what's to lose if the discount sticks?
Such is the case for Eli Lilly (NYSE:LLY). Lilly is currently trying to develop solanezumab, a drug that will attempt to halt Alzheimer's progression. Results from the trials are expected late this year. If the drug proves promising and clears the FDA, the impact could be enormous. There are an estimated more than five million Americans alone afflicted with the disease, and the number could grow as our baby boomers continue to age. The estimate for the globe is that over twenty-five million people are affected worldwide.
The benefits of such a positive event on society would be priceless, and to LLY this could mean billions in sales. And according to some analysts, this could appreciate LLY stock by 50%! However, many investors and traders believe that the approval of solanezumab by the FDA is unlikely, as the current stock price reflects. Nevertheless, I like the risk-reward to consider a position in a bullish options position in this scenario.
Also, the stock pays a hefty dividend yield of 5% which can also help support the stock. Given this set of circumstances I would consider either purchasing stock and puts, or constructing a bullish options spread constructed with January 2013 options.
Scenario I: Buy 100 shares of LLY stock @ $39 and buy one Jan. 2013 35 Put @ 2.00
Now let's fast forward in time to January Expiration of 2013. Our TOT P&L is based upon 100 shares and one put contract given the hypothetical stock price in the left column.
|Put P&L||Dividend*||TOT P&L|
*Div = $147 ( 3 x .49 May 14, August 13 and November 12 )
Scenario II: Buy one January 40 Call @ 2.60, sell one January 35 Put @ 2.05 and buy one January 30 Put @ .75.
Now let's fast forward in time to January Expiration of 2013. Our TOT P&L is based upon one options contract given the hypothetical stock price in the left column.
|Stock||30 Put||35 Put||40 Call||30 Put P&L||35 Put P&L||40 Call P&L||TOT P&L|
Like most analysts, I don't believe the stock will fall too much if LLY's solanezumab does not receive FDA approval. As such, I prefer Scenario II to Scenario I as it has a much lower break-even point, and I do get to participate on the upside if it does get the FDA's blessing.
In either scenario, I am limited to what I can lose. I prefer to minimize my risks as any unforeseen event can sideswipe any thesis, no matter how bulletproof it may seem to be.
If you are a seasoned trader, you may consider doing any variation of the above-constructed trade. My only suggestion is that you don't cap the upside, because an approval of this drug could really spark an influx of buyers into this stock.
Disclosure: I am long LLY.