Sell the News Could Deliver a 96% Gain on This Drug Stock
Trade summary: A bear call spread in Intercept Pharmaceuticals, Inc. (Nasdaq: ICPT) using June $80 call options for about $6.38 and buy a June $85 call for about $3.93. This trade generates a credit of $2.45, 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 $255. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($245). This trade offers a potential return of about 96% of the amount risked.
Now, let’s look at the details.
Buy the rumor, sell the news, according to CNBC, “is a market adage based on the belief that stock prices move in anticipation of rumors and rebound when profit taking occurs after the actual news is released.
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It’s a risky tactic of stock trading based on just rumors or moving events. The investor, who stands to make a nice profit on their stocks, then dumps positions as the news is announced.”
Sometimes, this strategy appears to work well as was recently the case in ICPT. The stock fell more than 10% after announcing that the FDA has postponed its advisor committee meeting for a new liver disease drug.
GlobeNewswire reported that “the postponement will accommodate the review of additional data requested by the FDA that the company intends to submit within the next week. The FDA has indicated that it will reach out to Intercept in the near future with a new proposed AdCom date.
Intercept now anticipates that the FDA’s review of its NDA will extend beyond the Prescription Drug User Fee Act (PDUFA) target action date of June 26, 2020.
“While this delay was unanticipated, following our most recent dialogue with the FDA we believe that the additional data being submitted will be important in facilitating a more informed discussion at the AdCom,” said Mark Pruzanski, M.D., President and Chief Executive Officer of Intercept.
“We remain confident in our NDA submission and look forward to continuing to work with the FDA to bring the first treatment to patients with advanced fibrosis due to NASH.”
Intercept previously announced the FDA’s acceptance of the NDA and granting of priority review. OCA has received Breakthrough Therapy designation from the FDA for the treatment of NASH patients with liver fibrosis.”
The stock fell sharply on the news as the chart below shows.
The longer-term chart using weekly data shows that the stock peaked almost three years ago and has repeatedly failed to reach new highs. This indicates the company could struggle, and analysts expect losses of more than $11 this year and over $7 next year.
While the stock appears to be weak, shorting 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 ICPT
For ICPT, we could sell a June $80 call for about $6.38 and buy a June $85 call for about $3.93. This trade generates a credit of $2.45, 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 $245. The credit received when the trade is opened, $245 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $255. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($245).
This trade offers a potential return of about 96% 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 ICPT is below $80 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 $255 for this trade in ICPT.
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.