A Breakout In A Healthcare Stock
Healthcare stocks are frequently reviewed by analysts. One review recently pushed a stock up. As Benzinga reported, “Davita Inc (NYSE: DVA) surged to all-time highs [recently] after winning the praise of a new market advocate. Medicare is largely to thank.
Goldman Sachs analysts led by Stephen Tanal upgraded Davita to Buy and raised their price target from $72 to $97.
Next year, the U.S. will expand eligibility for Medicare Advantage plans to people with preexisting end stage renal disease (ESRD). As of yet, the program captures only the ESRD patients who developed the disease after enrollment or who were eligible for special needs dialysis plans.
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“The 2021 ESRD rule change carries implications across the healthcare services ecosystem, as the 516,000 patients on Medicare with ESRD represent just 1% of all Medicare-eligibles but approximately 7% of total Medicare healthcare spending,” the analysts wrote.
“Only 26% or 132,000 of these patients are on MA today, a figure that could rise considerably in 2021 and beyond — especially if large MA plans find ESRD patients to be an attractive demographic.”
Davita is a certain beneficiary, with the Medicare change expected to increase revenue per dialysis treatment. Goldman Sachs suspects Davita’s Medicare Advantage rate exceeds its Medicare fee-for-service rate by 15%.
By the analysts’ base-case estimates, Davita could increase ESRD patients by four basis points and pre-tax earnings by 2.4% over prior forecasts.
In a bull-case scenario, EBITDA could rise 16.6% over previous forecasts. Either increase is expected to offset regulatory headwinds related to rule changes on care delivery.”
The stock’s recent move pushed it out of an extended consolidation pattern. Based on technical analysis, the stock price target could now be as much as $125.
The price target based on the chart pattern is well above the price target published by the analyst based on fundamentals. That is consistent with the behavior of many stocks which overshoot to the up side and the down side as traders make decisions based on emotions rather than fundamental factors.
Price moves based on emotion rather than fundamentals can be volatile and in the financial markets, volatility is often associated with risk. For that reason, it is especially important to manage risk.
A Trade for Short Term Bulls
As with the ownership of any stock, buying DVA could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for DVA
Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
For DVA, the April 17 options allow a trader to gain exposure to the stock.
An April 17 $85 call option can be bought for about $4.20 and the April 17 $90 call could be sold for about $1.60. This trade would cost $2.60 to open, or $260 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $260.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in DVA the maximum gain is $2.40 ($90 – $85= $5; $5- $2.60 = $2.40). This represents $240 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $260 to open this trade.
That is a potential gain of about 92% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.