A New Drug Sets Up a New Trade
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. 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.
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Promising Results from a New Drug
Sarepta focuses its research on the discovery and development of precision genetic medicines to treat rare neuromuscular diseases. The company already has one drug on the market for DMD, Exondys 51. That drug was approved on a conditional basis by the FDA last year pending more testing to confirm results.
Exondys 51 costs about $300,000 per year. The company’s CEO defends the high price of the drug, noting the high cost of research. “Sarepta is a small company. We have already invested $1 billion fighting Duchenne muscular dystrophy. And we’re not done yet,” CEO Doug Ingram told CNBC.
He conceded the pricing is an important question, noting “This a societal question more than a Sarepta question,” Ingram said. “I think it’s the right decision for society to invest in finding solutions for these rare disorders.”
And, these disorders are rare. Exondys 51 treats a mutation affecting about 13% of sufferers. DMD occurs in 1 in every 3,500 to 5,000 males worldwide. “Our goal is to treat 100 percent” of DMD suffers. “The data that we have this morning shows we’re on the right path,” Ingram added.
New Results Boost Stock
The new drug, golodirsen, was tested in Europe, in a study involving 25 boys with confirmed deletions of the DMD gene amenable to skipping exon 53. Exons are part of the DNA code. The treatment targets a genetic mutation affecting about 8% of patients with DMD.
The results, announced before Wall Street’s open bell, showed that golodirsen increased production of the protein dystrophin to 1.02% of normal levels from about 0.095% without the drug. Analysts said those results were higher than expected, but scientists wonder whether that’s enough to increase muscle strength and have a clinical benefit.
Despite the questions, the stock jumped on the news.
As the chart above shows, the stock has a pattern of jumping higher on news and then falling back. This is consistent with the fact that the company is a long way from profitability and is trading on the hope of a major research breakthrough.
Like many biotechs, the company does not have a history of profits and sales have been minimal. In the past twelve months, Serapeta reported revenue of $56.8 million and expenses of $304.3 million. Most analysts expect expenses to exceed revenue for some time.
The consensus estimate is for a loss this year. Consensus estimates are an average of all available analysts’ forecasts. For this year, twelve Wall Street firms have published estimates for the company.
For 2018, thirteen analysts have published estimates for Sarepta. The estimates average to a loss of $1.65 per share. But, the most optimistic analyst expects a profit of $0.68 per share.
In 2019, the consensus of nine published forecasts is for earnings per share (EPS) of $0.01. The most optimistic analyst is forecasting EPS of $2.19 while the most pessimistic forecast is a loss of $2.31.
The forecasts show that no one knows what lies ahead of the company. In this environment, it can be best to trade the chart since the price pattern shows have traders have been reacting to the news.
A Long Standing Pattern Appears on the Chart
For Sarepta, traders have been reacting consistently for several years. The monthly chart is shown below and it looks much like the daily chart shown above.
The company announces news quite often. This is normal for a company developing new drugs. In the case of SRPT, we see that traders buy when the news is released and then sell in the weeks after the announcement is made. This leads to volatility in the stock and a tradeable pattern.
After the most recent rally in the stock, it appears based on history that a decline is likely. Even if a decline doesn’t develop, there has rarely been significant follow through to the upside after a large rally in the stock.
That means, based on history, SRPT is likely to sell off in the near future, or at least consolidate its recent gains.
A Specific Trading Strategy
To trade a potential decline in the stock, a trader could buy a put. For SRPY, it’s not surprising that put options are relatively expensive. This is expected since traders know the stock often pulls back after announcing news.
The high price of the put option suggests an alternative strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in SRPT
For SRPT, we could sell September 15 $49 call for about $1.00 and buy a September 15 $50 call for about $0.65. This trade generates a credit of $35, which is the difference in the amount of premium for the call that is sold and the call that is bought multiplied by 100 since each contract covers 100 shares. That is the maximum potential profit on the trade.
The maximum risk on the trade is $65. The risk is found by subtracting the difference in the strike prices ($100) and then subtracting the premium received ($35).
This trade offers a return of about 53% for a holding period of a little more than one week. This is a significant return on the amount of money at risk. This trade benefits if SRPT is below $49 when the options expire, a likely event given the stock’s history.