Fighting Depression Creates a Possible Triple Digit Gain
Trade summary: A bull call spread in Sage Therapeutics, Inc. (Nasdaq: SAGE) using the October $65 call option which can be bought for about $3.80 and the October $70 call could be sold for about $2.10. This trade would cost $1.70 to open, or $170 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $170. The maximum gain is $330 per contract. That is a potential gain of about 194% based on the amount risked in the trade.
Now, let’s look at the details.
According to a report at The Street,
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“Wedbush analyst Laura Chico raised her rating on the biopharmaceutical company to outperform from neutral and lifted her share-price target to $64 from $40.”
As shown on the daily chart below, the stock moved up on the news.
The report continued, “She’s enthusiastic about zuranolone, the company’s developmental drug to treat depression.
Sage is evaluating the potential of zuranolone as a rapid-acting, short-course treatment for post-partum depression and major depressive disorder.
Sage reported a second-quarter net loss of $136.3 million, or $2.63 a share, narrowing from a loss of $168.2 million, or $3.28 a share, for the year-earlier period. Revenue rose to $1.1 million from $873,000.
In April, the company said it was laying off 340, or 53%, of its staffers, seeking to shore up its balance sheet amid challenges posed by the coronavirus. Sage also said it was slashing external expenses.
The company said it expected to save $170 million a year through the moves, with $150 million attributed to reducing selling, general and administrative costs.
Sage said the cuts were mainly focused on the operations and related support functions for its Zulresso, generically brexanolone, a treatment for new mothers experiencing postpartum depression.
“The headwinds we are facing individually and collectively, along with our recognition of our need to move forward as a company, have led to this difficult decision,” said Jeff Jonas, a physician who is chief executive of Sage, in a statement.”
These stories indicate that SAGE faces challenges but is taking steps to meet the challenges while analysts remain optimistic about its leading drug candidate.
The chart below uses weekly data and shows that the stock is well below its all-time highs.
Even at the 52 week lows, the stock carries risk. Analysts expect SAGE to report steep losses for at least the next two years. Losses could force the company to raise capital and that would reduce the amount of equity existing share holders own. The risk of dilution is just one of the risks investors face.
Given the high risks, a spread trade could be suitable for many traders who could enjoy significant upside while limiting potential losses.
A Specific Trade for SAGE
For SAGE, the October options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
An October $65 call option can be bought for about $3.80 and the October $70 call could be sold for about $2.10. This trade would cost $1.70 to open, or $170 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 $170.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in SAGE, the maximum gain is $330 ($70- $65= $5; 5- $1.70 = $3.30). This represents $330 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $170 to open this trade.
That is a potential gain of about 194% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying SAGE 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 of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will 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 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.