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Ivan Mutaftchiev
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Ivan Mutaftchiev has been managing accounts since 2002. Ivan searches the markets for profitable low-risk arbitrage opportunities such as mergers, takeovers, spinoffs and other special situations. Combining his dual experience in the investment industry and in the legal field, gives Mutaftchiev... More
  • Biotech Stocks - Beware of The Covered Call Trap 0 comments
    Nov 25, 2009 6:14 PM | about stocks: PARD, OSIR, GTXI

    Years ago when I worked in retail brokerage, I knew a broker at another firm, who specialized in pitching covered call plays. He would explain to clients how with covered calls you take your profits upfront and the premium you just collected gives you a nice cushion to the downside. Say you buy stock ABC at $10 and sell the $10.00 strike calls for next month at $2.00. If the stock price at expiration is at or above $10, your calls are assigned at $10 - you break even on the stock, and you keep your $2 premium for each of the calls, for a 20% profit. Even if ABC is down a bit, say at $9.50 at expiration, you still make money. The calls expire worthless, you are down $.50 on your ABC, but you still have your $2.00 from the call you sold, so your profit is $1.50 and you get to sell the calls against your ABC again next month. The only way you can lose money is if the stock is down more than the $2.00 per share you collected for each call. My fellow broker would promise clients to minimize a potential loss by putting a stop loss order for ABC at $9.00 and buy the depreciated calls back if the stock ever dropped to that level.

    Sounds like a good plan right ? I mean, how can you lose ? With the calls yielding 15% or 20% per month and minimum downside risk, this broker looked like a market genius signing up several new clients every day. Unfortunately, back then and to this day, there is no free lunch in the market and stocks that have high-yield calls are always the stocks with very high price volatility. The broker would pick the stocks with the most expensive calls, not bothering with what the companies actually did, because he "knew" he can always sell them if the price dropped 5-10%. By this method, his clients often ended up owning biotech stocks, which as an industry are not only some of the most volatile, but the absolute worse for selling covered calls against.

    I know of no other industry, where a single announcement could literally make or break a company. An FDA decision or the results of a pivotal experimental drug study routinely cause 50% moves in either direction. And since these announcements are usually made pre-market or after the market close, your $9 stop loss order will kick in when the market opens the next day, and your stock is already down from $10 to $5. Of course, you have to buy the calls back first before you sell your ABC at $5, otherwise you'd have the calls naked. Hopefully by the time you close your call position, the stock ABC has not dropped further down to $4. Yes you still have $2 profit on the call, but you just lost $6 on the stock, so overall you're down $4 or 40%. Of course if you had bought ABC on margin, you just lost 80% of your investment.

    Selling covered calls against biotech stocks was a recipe for disaster then and it remains so today. Below are 3 recent examples, that devastated the covered call sellers.

    Take a look at Poniard (OTCPK:PARD) which was trading around $7.00 all day on October 27. The December $7.50 calls were selling at $2.50. The calls yielded 36% over less than 2 months !!!! However this supposed boon for covered call sellers, turned into a bust when PARD opened at $1.77 on November 16th (down from $7.58 at the close of the previous day). The $2.50 call premiums collected, were small consolation for the $5.23 ($7.00 - $1.77) loss on the stock.

    Or let's say you bought Osiris (NASDAQ:OSIR) at $14.50 on September 02, and sold the Sept $15 calls for $2.50. Wow, that's 17% yield in 2 weeks ! However, just 6 day later, on September 8, OSIR opened at $7.40....That's a $7.10 loss on the stock (less the $2.50 you made on the calls) a loss of $4.60 or 32%.

    And here is another - GTX Inc (NASDAQ:GTXI) traded around $12.50 on September 21. One of the bests calls to sell was the November $15.00 which was selling for $2.80. Just 10 days later, the stock opened at $5.80 on November 2nd, a $6.70 loss on the equity for those who bought the stock at $12.50 (less their profit of $2.80 on the call of course).

    In the above examples I have quoted the opening prices the days the stocks collapsed as these were not gradual declines over several days giving investor a chance to get out, but overnight changes of value, that could not be avoided even if you had a stop loss order in place or were watching every tick in the price during market hours.

    Covered calls is a conservative strategy and in fact is the only use of options allowed in IRA accounts, but could bring disaster when not used wisely. Limit your covered call selling only to blue chip companies, that you already own. These calls will yield 1-2%, but stock price declines tend to be small and gradual, giving you plenty of time to take a small loss and get out. Don't be tempted by the expensive calls of risky companies, and NEVER sell covered calls on Biotechs.

    Disclosure: The author purchased $2.50 calls on PARD after it collapsed to its current levels.

    Stocks: PARD, OSIR, GTXI
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