A Possible New Drug Means a New Trade
News in the biotech sector often leads to large price moves in the stock of the company. This can, of course, mean a move up or down. If the news for the drug is good, the stock tends to move up. Bad news can push the stock lower.
This is a normal reaction. The news can have an important impact on the company’s future cash flow. This fully explains the market move. It’s information that is important to the market and the market, under the Efficient Market Hypothesis, immediately discounts that information.
Some traders worry that they missed the initial move and the stock no longer presents an opportunity. While it is true that they have missed the initial move, it is not true that there are no additional opportunities.
That’s the case for Global Blood Therapeutics, Inc. (Nasdaq: GBT).
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Big News Creates a Big Gain
According to Market Watch,
Shares of the company jumped after the biotech company announced “it had reached an agreement with the U.S. Food and Drug Administration to use an accelerated approval pathway for a potential sickle cell disease treatment.”
“Voxelator, a once-a-day oral drug, works by increasing the binding of oxygen to hemoglobin, the molecule that carries oxygen in red blood cells.
Global Blood thinks this would help prevent patients’ red blood cells from clumping together, which would decrease the risk of stroke for those patients.
Under the accelerated approval pathway, Global Blood will not need to conduct a clinical trial that proves voxelator reduces strokes until after the drug is approved, though it could be withdrawn after it hits the market if further studies show it doesn’t provide a clear benefit.”
That means there could be increased volatility in the stock. The longer term chart below shows that volatility could be to the up side and additional gains could be possible.
However, as with any volatile stock, there is a risk that the stock could move in the opposite direction of what a trader believes is likely. That’s why it is important to focus on risk and the risk can be controlled with many strategies.
This makes options strategies, in particular strategies known as spreads, especially appealing. These strategies offer a trader limited up side potential and strictly defined down side risks. Again, GBT offers an example.
A Trade for Short Term Bulls
As with the ownership of any stock, buying GBT 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 GBT
For GBT, the December 21 options allow a trader to gain exposure to the stock.
A December 21 $50 call option can be bought for about $1.92 and the December 21 $55 call could be sold for about $0.90. This trade would cost $1.02 to open, or $102 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 $102.
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 GBT the maximum gain is $3.98 ($55 – $50 = $5.00; $5.00 – $1.02 = $3.98). This represents $398 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $102 to open this trade.
That is a potential gain of about 390% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.