Benefit From News Related Price Declines
Many finance professors and investment professionals believe the stock market is at least somewhat efficient. In a perfectly efficient market, the current price of any stock would accurately incorporate all the information available about that stock. We know that markets are not perfectly efficient.
But, there are some aspects of the efficient market hypothesis (EMH) that are important to keep in mind. One is that markets do tend to react quickly to new information. This happens as traders and investors attempt to incorporate news into a stock’s price as quickly as possible.
We often see this process unfold after earnings are announced. A stock can make a large move on the day of this quarterly announcement. This is predictable under the EMH because the news represents brand new information that needs to be incorporated into the stock price.
News that causes price moves can include more than earnings report. A merger could, of course, cause a stock price to move. A new contract award is another example of the type of news that can move a stock price.
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In the drug and biotech industries, approval of a new drug or test results related to a drug in development can move stock prices. This news is usually important to the company since the success of a drug determines the company’s future profits.
Biotech Stocks Have Frequent New Driven Price Moves
This week, we saw news about a drug trial cause a large move in the stock of Portola Pharmaceuticals, Inc. (Nasdaq: PTLA).
Portola Pharmaceuticals is focused on the development and commercialization of therapeutics in the areas of thrombosis, other hematologic disorders and inflammation for patients having limited or no approved treatment options. The company’s two lead programs, Betrixaban and Andexanet alfa, address unmet medical needs in the area of thrombosis, or blood clots. Its third product candidate is Cerdulatinib.
On Thursday, there was news about Cerdulatinib, an oral, dual Syk-JAK inhibitor with a unique mechanism of action. It inhibits two key signaling pathways that promote cancer cell growth in certain hematologic malignancies: the B-cell receptor pathway via Syk and key cytokine receptors via JAK. With its dual pathway mechanism, cerdulatinib may be more effective in specific patients than a single pathway agent, such as those resistant to current therapies or those with known heterogeneous cellular mutations. Preclinical data suggested that cerdulatinib may have anti-tumor activity in patients who did not adequately respond to, or relapsed on, other treatments due to defined mutations.
Now, interim data from a Phase 2a study evaluating the drug in patients with relapsed/refractory B-cell malignancies is available. The data were presented by the chief of the Medical Oncology Service at Memorial Sloan Kettering Basking Ridge during the International Congress on Malignant Lymphoma (ICML) in Lugano, Switzerland. This was an independent study and is important to the drug’s future.
To date, overall response rates are as follows:
- 12 out of 18 (67%) partial responses (PRs) in patients with r/r CLL/SLL
- 5 out of 9 (56%) PRs in patients with r/r FL
- 1 out of 7 (14%) PRs in patients with other r/r iNHL (marginal zone lymphoma and Waldenstrom macroglobulinemia)
Results also showed that cerdulatinib was generally well-tolerated in patients (at target drug levels). However, three patients suffered severe adverse events.
The results seem to be encouraging and seem positive. Management now expects to provide an update and to make a decision on whether or not to move forward with the drug by the end of this year.
Even though the results seem positive, the stock sold off on the news. However, the chart below shows that the stock had rallied in anticipation of the news.
The chart appears to present an example of the old Wall Street saying to “buy the rumor, sell the news” and this is a pattern commonly seen in this industry.
The news about the drug was widely anticipated. Conferences and speakers are scheduled months in advance. Analysts covering the company knew results would be released at the conference. They would not have any insight into the results before then because it is illegal to leak the results before the formal announcement.
Leading up the conference, PTLA had more than doubled since the beginning of the year, a sign that traders expected good news and are likely anticipating a decision to move into stage 3 testing, the final phase of the drug development process.
By the time the news was announced this week, many traders had built up significant profits in the stock. They know there is likely to be a lull in news from the company for now and they seemed to see an opportunity to take profits. This was a classic example of “buy the rumor, sell the news.”
But, the selloff was relatively small. This is most likely because traders expect Portola to do well in the long run. Analysts expect the company to report large losses this year and next before turning profitable in 2019. Looking ahead, they understand the stock could be worth several times it current price.
Generate Income While Waiting For News
It is likely Portola will have additional news later this year. It is also likely the stock will find support near its current price as traders await that news. Support is a price level where the risk of further declines is low because investors believe the stock is a bargain at that price.
This means there is a buying opportunity in PTLA for long term investors and a trading opportunity for short term investors seeking income.
A put writing strategy can be used to generate income from the stock. This involves selling a put option with an exercise price below the current market price. The maximum gain on this strategy is equal to the premium received. The maxim risk is equal to the exercise price of the option less any premium received. The trade can always be closed prior to expiration to minimize any loss.
The risk profile for selling a naked put, from The Options Industry Council web site, is shown below.
One way to minimize the risk of put selling is to select an option with an exercise price substantially below the stock’s current market price. That is the strategy for today.
PTLA closed on Friday at $35.06. The July 21 $20 put is trading for $1.10. This is a put expiring on July 21 with an exercise price of $20. Selling the July 21 $20 put on PTLA will generate $110 in immediate income.
In order to be exercised, the stock price would have to fall more than 20%. That is unlikely according to an options pricing model that estimates the probability of a move of that size at about 11%. That implies an 89% probability of success for this trade.
This trade is a win if the price of PTLA holds steady or rises before the expiration date. It is profitable as long as the stock price remains above $20. If that happens, the trade delivers a 100% gain.
To enter this trade, your broker will require a minimum margin deposit. This amount will vary by broker but is generally equal to about 20% of the value of the exercise price multiplied by 100. In this case, the margin deposit will be about $400, which is 20% of the $20 exercise price multiplied by 100.
Based on the margin required, this trade offers a potential gain of about 27.5% based on the income generated on the margin deposit.
The high level of income demonstrates the value of a put writing strategy. Of course, the trade should be monitored until expiration. It could be closed prior to expiration to limit the loss or to book a profit as the price of the option changes.
This is a trade with a great deal of risk when measured in dollar terms since the risk is the stock could fall to zero. But, the probability of that is very small.
The trade offers a high amount of potential income and has a high probability of success based on pricing models. Overall, the trade will be right for some traders but may not be the best strategy for more conservative traders.