After a Big Rally, Here’s How to Benefit from This Stock
Some stocks move in trends that last for years. The trend may be up or down, but it is generally long lasting because of news. That was the case in recent years with Gilead Sciences, Inc. (Nasdaq: GILD) which moved higher and then lower on news.
As the chart below shows, the trends in the stock were extended, lasting for years.
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The strong rally came after the company discovered and marketed a treatment for hepatitis C. The down trend is due, at least in part, to the fact that drugs worked very well. The drugs the company developed cured the disease and patients would live without the disease after treatment.
This is, of course, good news for patients. But, a company that cures its patients eventually sees revenue decline and the market price reflects future growth potential of a company. Curing patients is good business but is bad for business and the stocks stumbles in the past three years reflect the shrinking pool of patients.
How Far Can the Rebound Take the Stock?
In recent weeks, the stock price is up almost 20% as analysts have been increasing their earnings and revenue estimates after the company reported earnings that topped analysts’ estimates by more than 22% and revenue was more than 8% better than expected.
The company’s results were driven by growth in the company’s treatments for HIV. The short term chart shows that the stock price has settled into a consolidation pattern.
The consolidation could hold until news triggers the next big move in the stock. Until then, the stock is likely to remain in a trading range. While some traders find trading ranges to be frustrating, this type of pattern does hold profit potential.
These strategies use options and the strategies can be used to strictly define the level of risk a trader accepts in dollar terms. That simply isn’t possible with stocks which can never be limited to less than 100% risk since stocks can fall to zero, even though that is unlikely.
Options are flexible tools and there are some strategies specifically designed to benefit from a relatively narrow trading range. These strategies can be ideal for traders expecting a stock’s trend to stall while waiting for the next news release from the company.
A Strategy to Benefit From a Trading Range
For Gilead, there is a relatively high likelihood of a narrow trading range now that the stock has moved sharply higher until the company provides news to push the price out of the range.
One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in GILD
For GILD, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, August 31.
The difference in the exercise prices of the calls or puts is equal to $1.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $150 less the premium received when the trade was opened.
Selling the options will generate $0.83 in income ($0.31 from the call and $0.52 from the put). Buying the options will cost $0.52 ($0.19 for the call and $0.33 for the put). This means opening the trade will result in a credit of $0.31, or $31 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.50) minus the premium received ($0.31). This is equal to $1.19, or $119 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $119 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.31 or $31 per contract.
The potential reward on the trade ($31) is about 26% of the amount risked, a high potential return on investment for a trade that will be open for about two weeks. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
This trade could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.
The iron condor 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 should be lower than owning the stock.
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.