Sometimes, A Good Product Can Destroy Its Market
We tend to think of products in the consumer space and things like Apples new phone captures our attention. The new phone seems to have features consumers love and it appears to be Apple’s best phone ever. Yet, we all know Apple will have a better phone in a couple of years.
We never consider the possibility that Apple could make a phone that was so good consumers would never upgrade. That sounds ridiculous. The same true for a number of other products. We would never believe Coca Cola will run out of customers or that consumers will stop buying clothes.
But, there is one market that is different. We actually hope that drug companies will come up with products that are so good that they cure the disease. Once the disease is cured, ideally, the patient never needs the company’s product again. And, one company faces that problem.
A Drug that Changed a Disease’s Course
Hepatitis C was once a disease that was chronic. Once infected, a patient could expect to require treatment for the rest of their life. This treatment included drugs meant to minimize the symptoms and if that didn’t work, there could be a liver transplant.
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That all changed when Gilead Sciences (Nasdaq: GILD) came out with a drug that cured hepatitis. There was no longer a plan to manage the disease. Physicians were able to cure the disease in as little as eight weeks.
Of course, this cure came at a price and the price tag was hefty. Gilead offered the pills at $1,000 each and the treatment cost $84,000 or more. This was the list price. Insurers and many consumers paid less. The patient would not require treatment after being cured. The high price was a bargain, in many ways.
This drug had a powerful impact on GILD, as well. The stock became one of the best performers in the market as the hepatitis drugs came to market.
The stock’s gains were driven by the impressive gains in sales that Gilead experienced. But, as the number of patients in treatment declined, the company’s sales have been falling.
Source: Standard & Poor’s
To reverse the trend in sales, and the stock’s price, the company needs another blockbuster drug. Gilead has been investing heavily in research and development over the years and may have another drug that will change the company’s fundamentals, again.
Could GILD Change Another Market?
Right now, Gilead and GlaxoSmithKline are both preparing to launch new products for patients with HIV. Analysts believe Gilead is likely to secure the bigger near-term win, as it builds on a 20-year-old strategy of combining three drugs to control the AIDS virus.
GlaxoSmithKline is placing a longer bet that its core drug is potent enough to work with just one other. If it succeeds, this drug could completely change the standard treatment by delivering cheaper two-drug regimens with fewer side effects.
Experts associated with Gilead aren’t sure this will work. They say the idea may risk drug resistance because the virus will only have to evade two drugs rather than three.
The potential market is worth $27 billion a year for HIV drugs. Gilead is the market leader with a 53% market share while GlaxoSmithKline has 22% of the market.
Whichever treatment proves to be more widely accepted will have a significant on the manufacturer’s bottom line. Both companies need a hit to push their stock price to new records. But, we won’t know which drug works best for patients for some time.
That means this is an issue that we should follow in the long term. Investors focused on the level of profits three or five years from now will need to understand how the acceptance of each drug in the market unfolds.
Traders with a shorter time horizon in mind can follow a different approach. From the shorter term perspective, the introduction of the new drugs is likely to lead to increased volatility in the prices of both drug makers.
Higher volatility is generally associated with higher options prices. This is because options prices reflect a number of factors. The price of a call or put option is affected by the price of the underlying stock, the current level of interest rates, the time left to expiration and the volatility of the underlying stock among other factors.
Increased volatility, when it leads to increased options prices, sets up a number of potential trading opportunities for options traders.
A Strategy to Trade GILD
GILD is likely to remain in a relatively narrow trading range while investors wait for news on the number of prescriptions being written and other details related to the new drugs. This indicates a significant move in the stock price is unlikely.
When a stock is expected to remain in a narrow range for some time, it is possible to generate income from the stock. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread that could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which recently saw increased volatility and is likely to remain in a narrow range.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
For Gilead Sciences, a bull put spread could be opened with the November 17 put options. This trade can be opened by selling the November 17 $70 put option for about $0.30 and buying the November 17 $67.50 put for about $0.10.
This trade would result in a credit of $0.20, or $20 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $2.50 ($70 – $67.50). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $230 ($250 – $20).
The potential gain is about 8.6% of the amount of capital risked. This trade will be for about one month and the annualized rate of return provides a significant gain.
Options pricing models indicate there is a 84% probability of a profit on this trade. This could make the trade appealing to risk averse investors.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.