Biotech Stocks Offer a Simple Trading Strategy
Biotech is a sector that can give traders the thrill of victory or the agony of defeat. Just like in a sports contest, the thrill or agony is triggered based on the results of a scorecard. The scorecard for biotech companies is often the results of drugs tests.
Drug testing is a long, complex and expensive process. The Federal Drug Administration (FDA) sets the rules and the rules are in place to ensure patient safety. Companies pass through the rigorous FDA process and report results of each step to investors.
The results from different phases of testing can have dramatic results on the price of the stock. This is often the time when investors who have a long term view of the stock win or lose. If the results are positive, the stock price can soar. Negative results can send the stock price down by double digits.
Trading After the News Can Also Be Profitable
Fortunately, there are some patterns traders can benefit from after the news is released and the stock makes its big move. With strategies designed to benefit from these patterns, traders can view news as an entry signal rather than the final score. Let’s look at an example.
Biogen Inc. (Nasdaq: BIIB) after the company delivered the results of its extended mid-stage test for its new Alzheimer’s drug. The Phase 2 trials showed deterioration slowed significantly in Alzheimer’s patients who received Biogen’s BAN2401 versus a placebo at 18 months.
According to TheStreet.com, “Patients who showed the most improvement in the trial were treated with the highest dose of the drug possible.
The drug, which is being developed with Japan-based Eisai Co. Ltd., is an antibody that latches on to and reduces the amount of amyloid plaques, according to Biogen’s product description. Amyloid plaques build up in the brain and are thought to be the cause of Alzheimer’s.
“The way we look at the data is that this is very encouraging validation of the beta-amyloid hypothesis,” RBC Capital Markets analyst Brian Abrahams said. “This idea that using an antibody to reduce the level of amyloid plaque in the brain can also produce concurrent clinical and symptomatic benefits.”
The stock price reacted favorably to the news.
But not all analysts are impressed.
Jefferies analyst Michael Yee remains cautious of Biogen and wrote investors have been “pretty bearish on Alzheimer’s” treatments because the disease is so difficult to treat.
He highlights the fact that there have been numerous setbacks in the development of an Alzheimer’s treatment, most recent being Eli Lilly and Co. and AstaZeneca PLC’s decision to discontinue their development of lanabecestat in mid-June.
Biogen will release more detailed results from the study at future academic conferences, according to a company press release. Until all the data comes out, William Blair analyst Matt Phipps also doesn’t see a reason to adjust his rating or estimates for the company just yet, he said.
“It’s nice to have some positive news for Alzheimer’s treatments, but it’s not a lot to go on,” Phipps said.
The study itself does seem to merit some skepticism. Initial results from the study released December 2017 showed no statistically significant improvement against the placebo at 12 months, which has added to the low expectations surrounding the drug, according to Guggenheim analysts.
Researchers analyzed the progress of the trial at several intervals to gauge the effectiveness of the drug and to change the dosage patients were receiving to better optimize their performance, which differed from how traditional Phase 2 trials are conducted.
This adaptive design “enriches in real-time doses that appear to be having the most benefits.”
For traders, the science can be interesting but the question is what comes next. History says biotech companies rarely give back much of their gains in the short term after a large gain based on news. But, the stock could face resistance at this point and upside could be limited until more news is released.
Options provide an appealing strategy for this situation.
A Trade for Short Term Bulls
As with the ownership of any stock, buying BIIB 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 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 BIIB
For BIIB, the July 20 options allow a trader to gain exposure to the stock.
A July 20 $365 call option can be bought for about $3.00 and the July 20 $360 call could be sold for about $4.00. This trade would cost $1.00 to open, or $100 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 $100.
The maximum gain on the trade in BIIB is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in BIIB the maximum gain is $4.00 ($365 – $360 = $5.00; $5.00 – $1.00 = $4.00). This represents $400 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 300% 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.