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After the Crash

After the Crash

Investors often think of a crash in terms of the market. Some worry about how a crash will affect their portfolio, wondering how they will recover. By definition, market crashes are rare events and rarely occur.

Despite the fact that a crash is unlikely to occur, many investors focus on that possibility. In doing so, they may be missing a bigger risk. There is a risk that a single stock can suffer a crash. This is especially true of small companies in the tech or biotech sector.

Earlier this week, biopharmaceutical company Axovant Sciences Ltd. (Nasdaq: AXON) crashed, falling about 70% on Tuesday. Not surprisingly, the crash was driven by news related to a drug test. The company said its experimental Alzheimer’s drug failed a key late-stage trial.

A Disappointing Outcome

The drug, called intepirdine, was being tested in patients that suffered from mild to moderate Alzheimer’s and who did not respond to initial treatments. According to experts, the drug was never seen as a cure, but the company had hoped it would delay the worst symptoms of the disease.

Alzheimer’s is a type of dementia that causes problems with memory, thinking, and behavior; symptoms develop slowly and worsen over time, becoming severe enough that they interfere with daily life. Alzheimer’s affects more than 5 million Americans, and is the sixth leading cause of death in the U.S.

While there is no current cure of Alzheimer’s, there are treatments available for symptoms. But only four drugs have been approved to treat symptoms, with the most recent drug approval in 2003.

Patient advocates point out that giving patients just a few more months of health before needing around-the-clock care would be beneficial. Patients, and the families and caregivers of patients, had high hopes for the drug.

Investors were also optimistic. Axovant was worth more than $2.6 billion before the news of intepirdine’s failure. The company rose to that multibillion dollar level of valuation on the hope that intepirdine could slow cognitive decline when paired with a generic memory-booster called Aricept.

This was the latest test for interpirdine, which had failed in four previous trials. This test involved more than 1,300 patients with mild to moderate Alzheimer’s. The combination of intepirdine and Aricept failed to outpace the old drug alone, missing its key goals of improving memory and physical function.

Axovant has built up high hopes for intepirdine which it bought from GlaxoSmithKline for just $5 million in up front costs and a promise to share in the future profits. The late-stage trial was highly-anticipated but left the CEO of the company disappointed.

“While we are deeply disappointed by these trial results, we also are saddened for the millions of patients and families impacted by Alzheimer’s disease,” Axovant CEO David Hung said. “However, we believe that the fight against Alzheimer’s and other important areas of unmet need in neurology is too important to be derailed by this setback.”

The company is now testing intepirdine in patients that suffer from a condition known as Lewy body dementia, a neurodegenerative disease with symptoms similar to those of Alzheimer’s or Parkinson’s. The results from these tests are expected before the end of the year.

The company will also test the drug in patients whose dementia is affecting their balance and gait.

The Stock’s Selloff is Steep

Avoxant began trading about a year ago with an initial public offering (IPO) in September 2016. The stock was up by more than 67% at its peak, just a week before the test results were announced.

Those gains were driven mostly by hope that the drug tests would be successful. Analysts who follow the company and have expertise in evaluating drugs should have seen warning signs that success was unlikely.

GlaxoSmithKline had stopped its development efforts after the drug after it failed multiple clinical trials. Axovant raised hopes by promising results that were not seen by one of the world’s largest drug makers.

As Bloomberg noted, “In those failures, Axovant saw opportunity, saying the drug showed a benefit if you looked at it the right way. It was so convinced that it was ready to dive into a large and (it said) better-designed final-stage trial in pursuit of FDA approval.”

In hindsight, the test results and the stock market’s reaction may have been foreseeable. The stock’s sell off now puts the price below the price seen in early trading.

This sell off means all investors who bought after the company’s IPO faced a loss. Only investors who bought this week would be able to show a profit in the company. This could lead to additional selling, especially among individual investors.

In the fourth quarter, many individual investors will review their portfolios as part of a tax planning process. This year, which has so far been a bull market for stocks, many investors will be facing significant tax bills. They can reduce those bills by selling losers.

Given that almost all investors who own Avoxant show a loss, selling to recognize a loss for tax purposes could have a significant impact on the stock. This could push the price even lower into the end of the year.

A Specific Trading Strategy

To trade a potential decline in the stock, a trader could buy a put. For AXON, it’s not surprising that put options are relatively expensive. The stock is in a downtrend and its recent selloff led to increased volatility which raised options premiums.

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 AXON

For AXON, we could sell an October 20 $7.50 call for about $0.45 and buy an October 20 $10 call for about $0.05. This trade generates a credit of $40, 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 $210. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 time 100 since each contract covers 100 shares) and then subtracting the premium received ($40).

This trade offers a return of about 19% for a holding period that is less than one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if AXON is below $7.50 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $210 for this trade in AXON.

You can find more trades like this in the TradingTips.com service, Options Cash Cow. To learn more, click here.

 

 

 

 

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