Some Risk Relief For Gilead Longs

| About: Gilead Sciences, (GILD)
This article is now exclusive for PRO subscribers.


As Friedrich Research noted recently, investing in Gilead and other biotechs involves more risk than investing in stocks in other industries.

With that in mind, we present two ways for Gilead longs to limit their risk over the next several months.

We also look at dark pool data to see how institutions have been trading Gilead there in the run up to its earnings release.

Screen capture via BIng.

Not For The Faint-Hearted

In his excellent comparative analysis of Gilead Sciences (NASDAQ:GILD) to Valeant Pharmaceuticals (NYSE:VRX) recently, Seeking Alpha contributor Friedrich Research offered a warning about investing in Gilead and the biotech/pharmaceutical industry in general:

Wall Street operates with a "what have you done for me lately" mindset and does not view Gilead Sciences as a unique special situation for the long term. Therefore, investing in the pharmaceutical/biotech industries is not for the faint-hearted as it requires one to take on more risk, as there are usually many more uncertainties and surprises involved in such investments than investing in a Wal-Mart (NYSE:WMT), for example.

Even consumer stocks have had some new risks recently, as we noted yesterday (Super Bowl LI Lessons). But Friedrich Research's point about the unique risks of Gilead and biotechs stands. Below, we'll look at a couple of ways Gilead longs can reduce their risk, but first we'll consider how institutions have been trading Gilead in dark pools in the run-up to today's earnings release. Recall that dark pools are private exchanges where institutions trade shares without the transparency of public markets. This enables them to place large block trades away from front-runners and other predatory traders on public exchanges. Readers may remember that institutions were heavy sellers of Gilead after its earnings miss last summer. They weren't the only sellers, as investor Adam Singer's reaction on Twitter at the time illustrated (fans of Kevin Smith's 1994 indie classic movie Clerks will catch his reference).

Screen Capture via Twitter

Since then, shares of Gilead have slid close to 11%.

Screen capture via YCharts.

To see what institutions have been doing with Gilead shares in dark pools recently, we logged into Squeeze Metrics (we have an affiliate relationship with the site and are compensated if readers join) and pulled up a chart going back to the beginning of the year. Since then, on all but two trading days, institutions have been net sellers of Gilead in dark pools. That chart would be too detailed to view at the resolution available here, so here is a chart going back 10 trading days to give you a sense of more recent trading in the stock.

Screen capture via Squeeze Metrics.

We've highlighted Monday there so you can see in the box in the top left that its DPI, or Dark Pool Indicator, was 39%. That means that 61% of dark pool trades in the stock were sells (if you're wondering how there can be more sells than buys in dark pools, it's because sales often get routed to intermediaries such as high frequency trading market makers. Those intermediaries can then unload the shares on public exchanges). The DPI was as high as 44% on January 25th, but on none of those 10 trading days did it rise above 50%, into bullish territory.

The institutions selling Gilead in dark pools could be wrong, of course. But with that and the general risk associated with the industry that Friedrich Research noted, some Gilead longs may want to consider adding downside protection.

Adding Downside Protection To Gilead

We'll look at two ways to hedge Gilead here, but remember: hedging is for bullish investors who want to limit their risk, not for bears (who shouldn't own the stock). If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in this previous article of ours, Locking In Gold Gains.

Hedging GILD With Optimal Puts

We used Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge GILD below, but you don't need the app for that. You can find optimal puts and collars yourself by using the process we outlined in this article, if you're willing to work out the math.

Whether you run the calculations yourself or use the app, an additional piece of information you'll need to supply (along with the number of shares you're looking to hedge) when scanning for an optimal put is your "threshold" which refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 14%. If you are less risk averse, you could use a larger one. All else equal, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts, as of Monday's close, to hedge 500 shares of GILD against a greater than 14% drop by mid-August.

Screen capture via the Portfolio Armor iOS app.

As you can see at the bottom of the screen capture above, the cost of this protection was $1,300 or 3.59% of position value. A few points about this cost:

  1. To be conservative, the cost was based on the ask price of the put. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 14% threshold includes this cost, i.e., in the worst-case scenario, your GILD position would be down 10.41%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts so they may provide more protection than promised if the underlying security declines in the near term when the puts may still have significant time value.

Hedging GILD With An Optimal Collar

When scanning for an optimal collar, you'll need another number in addition to your threshold, your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. One starting point for the cap is your estimate of how the security will perform over the time period of the hedge - you don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

We checked Portfolio Armor's website to get an estimate of GILD's potential return over the next several months. Every trading day, the site runs two screens to avoid bad investments on every hedgeable security in the U.S. and then ranks the ones that pass by their potential return. Gilead didn't pass both tests, so the site didn't estimate a potential return for it. So, we used the highest cap we could while canceling out the positive hedging cost. That cap ended up being 10%.

As of Monday's close, this was the optimal collar to hedge 500 shares of GILD against a greater than 14% drop by mid-August, while not capping an investor's upside at less than 10% by then.

Screen capture via the Portfolio Armor iOS app.

As you can see in the first part of the optimal collar above, the cost of the put leg was $975, or 2.69% of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was $1,085, or 3% of position value.

Screen capture via the Portfolio Armor iOS app.

So the net cost was negative, meaning you would have collected $110, or 0.3% of position value, when opening the hedge. A couple of notes on this collar:

  • Similar to the situation with the optimal puts, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask). So, in reality, an investor would likely have collected more than $110 when opening this collar.
  • Due to time value, this hedge may provide more protection than promised if GILD declines in the near future. However, if GILD spikes in the near future, time value can have the opposite effect, making it costly to exit the position early.