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Politics Can Create Swings In Stocks

Politics Can Create Swings In Stocks

There are times when stock prices react to more than fundamentals. There could be geopolitical events that move the stock market and almost every stock in the same direction. At times, there could be political debates that move a sector.

An example of the latter was recently noted in a CNBC article about the health care sector which noted,

“News surrounding the fate of former President Barack Obama’s signature health law and Sen. Bernie Sanders’ new “Medicare for All” bill also weighed on the industry’s shares.

Health-care stocks were [weak] after lawmakers on Capitol Hill threatened to write new laws tightening control over the nation’s largest pharmacy benefit managers to curb skyrocketing drug costs.

The Trump administration’s legal challenge to former President Barack Obama’s signature health insurance law, the Affordable Care Act, and Sen. Bernie Sanders’ new “Medicare for All” bill also weighed on the industry’s shares.

The XLV, an ETF that tracks the health-care industry’s biggest companies, was down …

XLV daily chart

The biggest declines were from insurers Anthem, Humana and UnitedHealth Group….

UNH daily chart

Executives from CVS Health, Cigna, Prime Therapeutics, Humana and UnitedHealth’s OptumRx testified about rising prescription drug costs before the Senate Finance Committee …

The PBMs left the congressional hearing mostly unscathed but Chairman Sen. Chuck Grassley, R-Iowa, hinted that the committee is ready to write new laws to bring down drug prices.

Ana Gupte, senior health-care services analyst at Leerink Partners, said the health-care sell-off is mostly driven by the proposed legislative changes to the PBMs’ business model, which are paid so-called rebates by Big Pharma for getting their drugs covered by private and public insurance plans, like Medicare.

These so-called backdoor deals are suspected by lawmakers of increasing drug costs for patients.

It is “very likely” lawmakers force drug companies to give those rebates to consumers instead, starting as early as next year, Gupte said.

Ross Muken, an analyst at Evercore ISI, told clients in a note that watching the industry’s shares fall has “not been fun,” but added he expects first-quarter earnings to be positive as “fundamentals generally remain positive and utilization still appears under control.”

A Trading Strategy to Benefit From Potential Weakness

The prospects of a further short-term gains in UNH seem to be remote.  But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.

This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.

bear put spread

Source: The Options Industry Council

A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.

Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

The Trade Specifics for UNH

The bearish outlook for (NYSE: UNH), at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.

A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive.  The risk of loss when buying an option is equal to 100% of the amount paid for the option.

To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.

Specifically, the May 17 $230 put can be bought for about $12.15 and the May 17 $220 put can be sold for about $7.21. This trade will cost about $4.94 to enter, or $494 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.

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 $494. This loss would be experienced if UNH is above $230 when the options expire. In that case, both options would expire worthless.

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 UNH, the maximum gain is $5.06 ($230 – $220 = $10; $10 – $4.94 = $5.06). This represents $506 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $494 to open this trade.

That is a potential gain of about 101% of the amount risked in the trade. This trade delivers the maximum gain if UNH closes below $220 on May 17 when the options expire.

Put 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 ths strategy. Those risks, in dollar terms, are relatively small, about $403 for this trade in UNH.