The Worst Stock on a Bad Day
When stocks plummet, we expect almost all stocks to close lower on the day. While 90% of the stocks might be down on a day like that, it might seem like there is not any tradable information in a company that is down.
But, the largest percentage declines sometimes tell us a great deal. That was the case when stocks sold off on Thursday, driven down by concerns about Facebook and other tech stocks along with worries about inflation, the Federal Reserve and a possible trade war.
A Drug Maker Suffers a Selloff
Even if the day had been bullish, it’s likely AbbVie (NYSE: ABBV). The stock’s decline undercut key support on the daily chart shown below.
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AbbVie announced that it will not try for accelerated approval of rovalpituzumab tesirine in third-line relapsed/refractory small cell lung cancer based on the drug’s results in a phase 2 trial and the “magnitude of effect across multiple parameters.”
The decision was made after consulting with the Food and Drug Administration (FDA) according to the company.
AbbVie said it does still believe the drug, also called Rova-T, has potential in small cell lung cancer and other cancers expressing the DLL3 protein, and Rova-T continues to be studied in ongoing phase 3 trials for first-line and second-line small cell lung cancer.
There had been high hopes for the drug, which AbbVie bought Rova-T in a $5.8 billion deal for Stemcentrx in 2016. At that time, Rova-T was the company’s most important asset.
The news came as a result of a study that tested the company’s Rova-T as a treatment for patients with small cell lung cancer who failed to respond to at least two prior regimens. Analysts believe the drug is central to AbbVie’s push to strengthen its cancer portfolio and reduce reliance on blockbuster Humira, which currently accounts for more than 60% of overall sales.
Late-stage trials testing the drug as a treatment for patients in the earlier stages of the disease will continue, the company said.
“Although the results from the study were not what we hoped for, we look forward to receiving data from the ongoing Phase 3 studies in the first- and second-line settings,” said Mike Severino, the company’s chief scientific officer and executive vice president of research and development.
The stock’s down move breaks a long standing up trend.
The chart shows higher than average volume when the stock broke out to the upside in February. Buyers at that time now have a loss and could be selling their positions. This all indicates the most likely direction of the short term trend in AbbVie is down.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in ABBV seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.
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.
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.
The Trade Specifics for ABBV
The bearish outlook for ABBV, 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 options 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 April 20 $95 put can be bought for about $3.00 and the April 20 $90 put can be sold for about $1.40. This trade will cost about $1.60 to enter, or $160 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 $160. This loss would be experienced if ABBV is above $95 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 ABBV, the maximum gain is $3.40 ($95 – $90 = $500; $5.00 – $1.60 = $3.40). This represents $340 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $160 to open this trade.
That is a potential gain of about 112% of the amount risked in the trade. This trade delivers the maximum gain if ABBV closes below $90 on April 20 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
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 this strategy. Those risks, in dollar terms, are relatively small, about $160 for this trade in ABBV.