Sometimes, the Market Gets It Right
Traders are often concerned that the stock market overreacts to news. For example, a stock may sell off after an earnings report and the selling may push the stock down by too much. The result is that buyers come in and the stock rebounds slightly as traders correct the initial overreaction.
This is actually common and is the basis of mean reversion trading strategies. In this type of trading strategy, a trader looks for stocks that have moved quickly and takes a position designed to benefit from a move in the opposite direction.
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To find stocks that moved “too far” a trader can use a variety of technical indicators or they can simply look at the magnitude of the price move.
A Double Digit Loss Might Not Be an Overreaction
Puma Biotechnology, Inc. (Nasdaq: PBYI) fell more than 15% after reporting earnings. The earnings report was actually better than expected with a loss of $0.65 beating expectations for a loss of $0.75 per share.
But, traders focused on the outlook for the company’s first commercial product, a cancer drug called Nerlynx. The drug is intended as a treatment to stop breast cancer from recurring following treatment with Herceptin.
Some analysts expect Nerlynx sales to reach at least $1 billion a year. But, the drug has severe side effects and Puma reported that 23.7% of patients stop using Nerlynx during a standard course of treatment because of severe side effects that adversely affect their quality of life.
The company believes that the discontinuation rate is falling, stating that the rate of patients who stop therapy due to side effects has only been around 12% since the drug launched last July.
That may be true, but the drug faces other challenges. The $1 billion a year sales estimates assume that the drug will be approved for use in Europe and that is far from certain. Reports indicate that “a negative committee opinion nearly dashed those hopes earlier this year. Puma expects to hear about a reexamination of that opinion in June or July.”
All of this explains the steep sell off in the stock price.
Now, the company does have some arguments for a higher stock price.
The drug is currently being tested in 600 patients as a third-line breast cancer treatment. “The trial completed enrollment last July, but the rate of disease progression among patients has been slower than historical data suggested when the company promised speedier results.
If Nerlynx is causing the slower disease progression rate, the stock could recover some of its recent losses. Investigators will unblind the data once a certain number of progression events occur, probably in the fourth quarter.”
That could be good news and could spark a rally in the stock. In the meantime, the stock is likely to remain volatile. The next chart includes a volatility indicator that shows how elevated that characteristic has become in recent weeks.
With high volatility, options trading strategies should be considered. It also seems unlikely that PBYI will make a strong recovery from the recent sell off.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in PBYI
For PBYI, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a June 15 $60 call for about $2.50 and buy a June 15 $65 call for about $1.25. This trade generates a credit of $1.25, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $50. The credit received when the trade is opened, $1.25 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $375. The risk is 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 ($125).
This trade offers a potential return of about 33% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if PBYI is below $60 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 $375 for this trade in PBYI.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.