Coronavirus Won’t Help This Drug Company But Could Deliver Gains
Trade summary: A bear call spread in Gilead Sciences, Inc. (Nasdaq: GILD), using April 17 $72.50 call options for about $9.89 and buy an April 17 $75 call for about $8.90. This trade generates a credit of $0.99, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $151. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($99). This trade offers a potential return of about 65% of the amount risked.
Now, let’s look at the details.
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Shares of Gilead Sciences (Nasdaq: GILD) a top contender in the race to develop a coronavirus vaccine, fell sharply … after a downgrade by analysts at RBC Capital Markets.
Gilead’s stock price [fell] after a relatively modest downgrade by RBC to outperform, a decline also likely fueled as well by the general market rout following a price war in oil. Gilead had previously been rated as a top pick by RBC.
Along with dropping their rating on Gilead a notch, analysts at RBC kept their price target on the biotech steady at $86 a share.
While RBC noted it expects “further upside” from Gilead, analysts at the firm wrote they are growing wary of the relatively high valuation of the drug development company’s share price, currently trading at 11.8 times its estimated 2020 earnings.
Gilead’s stock is up [more than 20% since] the start of the year, compared to a double-digit decline in the Standard and Poor’s 500 index over the past month.
RBC said it has been high on “underappreciated sustainability” of Gilead’s 11 different HIV medications, the biotech’s approach to business development, and its “undervalued pipeline/antiviral prowess.”
That said, “our bullish thesis … is beginning to play out,” analysts at the firm wrote.
Gilead has launched Phase III testing on Remdesivir, developed as a possible Ebola treatment, on coronavirus patients in China, looking at two different groups, one with severely ill patients, the other with those only moderately ill.
RBC sees the coronavirus drug trials as a way Gilead can maintain its position as a “defensive play” amid the current market tumult.
The downgrade comes as GILD faced resistance at 2017 highs. Investors who bought at that time were potential sellers after enduring losses for more than two years and being given the chance to get out at a breakeven price. This is a classic course of resistance.
The reversal creates a potential opportunity to benefit from capitulation selling which is now possible after the stock price failed to break through resistance.
Buying shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for GILD
For GILD, we could sell an April 17 $72.50 call for about $9.89 and buy an April 17 $75 call for about $8.90. This trade generates a credit of $0.99, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $99 The credit received when the trade is opened, $99 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $151. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($0.99).
This trade in GILD offers a potential return of about 65% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if GILD is below $72.50 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 $151 for this trade in GILD.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.