A 50% Rally Sets Up a Trade for Bulls
Sarepta Therapeutics (Nasdaq: SRPT) posted a double digit gain after reporting encouraging results from a clinical trial of an experimental medicine for Duchenne muscular dystrophy (DMD), one of nine types of muscular dystrophy.
Symptoms of DMD generally begin to appear in early childhood, usually between ages 3 and 5. DMD occurs in 1 in every 3,500 to 5,000 males worldwide.The disease primarily affects boys, but in rare cases it can affect girls.
Muscle weakness can begin as early as age 3, first affecting the muscles of the hips, pelvic area, thighs and shoulders, and later the skeletal (voluntary) muscles in the arms, legs and trunk. By the early teens, the heart and respiratory muscles also are affected.
Until relatively recently, boys with DMD usually did not survive much beyond their teen years. Thanks to advances in cardiac and respiratory care, life expectancy is increasing and many young adults with DMD attend college, have careers, get married and have children. Survival into the early 30s is becoming more common, and there are cases of men living into their 40s and 50s.
Elevated serum creatine kinase levels are often used as a preliminary diagnosis of Duchenne muscular dystrophy.
The company reported data from an early-stage study testing its gene therapy in patients with Duchenne muscular dystrophy (DMD). Sarepta said data from the three-patient study showed an 87% mean reduction in serum creatine kinase levels, which is used as a preliminary diagnosis tool for DMD.
The stock rallied sharply on the news. The rally reflects the results of this test and also the success of the company’s technology. It is possible that other drugs in the company’s pipeline could deliver similar results.
At its high, the stock was more than 65% above the previous day’s close. This is a strong rally, but traders who missed could still have an opportunity in the stock.
It is probably late to buy into the stock unless a trader specializes in biotech stocks and understands the science behind the test and the timeline of future results. These investors have an edge in the market and could define risk in more precise terms.
However, we do know, in general terms, how other stocks in similar situations have performed in the weeks after large gains were announced. In a test on biotech stocks showing large one day gains using data back to 1982, most of the stock pulled back slightly but maintained a majority of their gains.
This information pointed towards a trading strategy in SRPT. Based on history, we know that there is a chance the stock could move up over the next month, but the odds favor a pullback. Shorting the stock to benefit from a pullback is a high risk strategy, and one that is not suitable for many traders.
Buying a put option could benefit from a decline but after the recent volatility in the stock price, put options are expensive. That indicates selling a put can be the better strategy because the large price move has created attractive opportunities for put sellers.
Using a put at least 10% below the current market price minimizes the risks since pricing models indicate a 90% probability of success. A spread reduces the risk even more.
Trading the Trend
When a stock is expected to move higher or pull back slightly, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for SRPT
For SRPT, a bull put spread could be opened with the July 6 put options. This trade can be opened by selling the July 6 $140 put option for about $3.75 and buying the July 6 $135 put for about $2.75.
This trade would result in a credit of $1.00, or $100 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($140 – $135). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $400 ($500 – $100).
The potential gain is about 25% of the amount of capital risked. This trade will be open for about two weeks and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.