Another Drug Stock Trade
Lately, drug stocks have been among the most actively traded. It seems that at least once a week, news pushes a stock in the sector up or down by a large amount. Unsuccessful traders look at the move and feel regret about missing it. Successful traders take the opportunity the market gives them.
The feeling of regret, or the lack of that feeling, is important in trading. Successful traders understand that there is no need to regret missing a move in a stock. The market consists of thousands of stocks and another opportunity is always present.
Traders with relatively small accounts may regret that they don’t have enough trading capital to take a large number of positions that could allow them to have exposure to the next big move. This is also not a feeling that successful traders have.
Remember, the truth is the market consists of thousands of stocks. We don’t know which will be the biggest gainer or loser tomorrow so no matter how much money we have we can never ensure we own the day’s biggest winner.
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What we can do is react after the news comes out. This strategy could still offer large profits and it actually lowers risks on many trades. Before looking at that strategy, let’s look at some news.
The News is Bad for Teva
The Food and Drug Administration (FDA) approved Mylan’s generic versions of Copaxone, a multiple sclerosis drug made by Teva Pharmaceutical Industries Limited (Nasdaq: TEVA). Shares of Mylan soared on the news while shares of Teva plunged.
The approvals were for a 20-milligram daily dose and for 40-milligram shots three times per week. The 40-milligram approval is the first generic at that dose. Novartis’ (NYSE: NVS) Sandoz and Momenta Pharmaceuticals (Nasdaq: MNTA) got approval for a 20-milligram daily Copaxone generic, Glatopa, in 2015.
Analysts were caught off guard by the approvals. They had expected the FDA to approve generic Copaxone sometime in 2018. The FDA, however, has been working to speed the approval of generic drugs for several months.
Mylan is perhaps best known as the maker of Epi-pens, a product that it helps patients obtain with education and limited financial assistance. Significantly, the company announced a patient support service dubbed Mylan MS Advocate to help ease patients off branded Copaxone.
This will include an interactive mobile app, in-home injection training, a 24/7 call center, copay assistance for eligible patients and support from a nurse experienced at treating MS.
Analysts noted this will have an adverse impact on teva. “Bottom line, this is incrementally positive for Mylan while for Teva both a negative surprise and a cash flow hit to 2018,” RBC analyst Randall Stanicky wrote in a note to clients. He reiterated his underperform rating on Teva stock.
Teva is fighting back. The company is suing five companies, including Mylan, claiming they infringed on a patent covering the manufacturing process for Copaxone. All five companies are working to bring generic copies of the MS drug to the market.
Teva expects Mylan’s generic launch to erase $0.25 in earnings per share from its fourth quarter results. RBC’s Stanicky noted Teva had previously predicted one or two generics could lead to $1 billion to $1.3 billion in annual revenue downside and a $1 hit to per-share earnings.
“Teva previously guided to slow Copaxone deterioration due to the stickiness of its patient support program which could play out initially,” he wrote. However, Mylan’s patient support program “should drive more switching over time.”
Consensus numbers project 9% erosion to Teva’s Copaxone in the fourth quarter and a decline of 39% in 2018, Evercore analyst Umer Raffat wrote in a note to clients. He expects Teva to “have to dig deeper for additional cost cuts to offset some of this.”
“We believe the company gaining approval on both strengths of Copaxone not only validates Mylan’s core competency as a premier generics company, it also provides an important signal to investors that one can simply never count out Mylan — especially in the area of complex generic products,” he said.
A Specific Trading Strategy
The news sent shares of TEVA lower but Teva was already in a downtrend.
This seems to confirm sellers were right and TEVA is unlikely to deliver a significant rebound until the company delivers good news. At the earliest, this could be mid-November when the next quarterly announcement is due. In all likelihood, the stock will remain under pressure from sellers.
To trade a potential decline in the stock, a trader could buy a put. For TEVA, 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. This is normal when a steep selloff occurs.
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 TEVA
For TEVA, we could sell an October 20 $16.50 call for about $0.58 and buy an October 20 $18 call for about $0.18. 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 $110. The risk is found by subtracting the difference in the strike prices ($150 or $1.50 time 100 since each contract covers 100 shares) and then subtracting the premium received ($40).
This trade offers a return of about 36% for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if TEVA is below $16.50 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 $110 for this trade in TEVA.