This Company Could Decline More, and Deliver Gains as It Falls
Value investors often seek companies with low price to earnings (P/E) ratios or other fundamental metrics. Of course, to have a P/E ratio, the company must have earnings. However, not all companies will have earnings.
Some companies will go public and begin trading so that they can raise capital to invest in their operations. This is a fairly common business model in the biotech sector. Companies in that sector need large amounts of capital to complete research studies and to bring drug candidates through the testing process.
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Because they go public, it is not uncommon to see companies in this sector report losses for several years. Investors understand patience will be rewarded in many cases when the company secures approval of the drug.
But, there are also risks since there is no guarantee a company will make it through the approval process. To reduce risks, investors often look for strong management teams that know the company, understand the science behind the drug and are committed to bringing products to market.
A Surprising Management Change Sends This Stock Reeling
Because management is so important, sudden changes in management can send a stock price down. That was the case with Portola Pharmaceuticals, Inc. (Nasdaq: PTLA) recently.
Portola Pharmaceuticals is focused on the development and commercialization of therapeutics in the areas of thrombosis, other hematologic disorders and inflammation for patients having limited or no approved treatment options.
The company’s two lead programs address unmet medical needs in the area of thrombosis, or blood clots. The stock has been trading since 2013.
In the short run, the stock’s latest setback came after the CEO, Bill Lis, decided to retire. Lis joined Portola in 2008 as vice president of business and commercial operations. He was promoted to chief operating officer in 2009, and then again to CEO in 2010.
Under Lis’ leadership. The company developed AndexXa and Bevyxxa, a drug for use in patients at risk of clotting after hospitalization. He secured a go-ahead to begin marketing Bevyxxa in December 2017, and more recently, the FDA gave a green light to AndexXa in May 2018.
According to analysts, “the approvals are significant because Bevyxxa and AndexXa have billion-dollar blockbuster potential.” But, now, some traders believe the management change could provide an opportunity for the company to be acquired.
The stock price has been volatile as the news and speculation swirled around the company.
Now, the stock appears to have failed to break through resistance and is near the lower end of a trading range that seems unlikely to provide significant support. The price could fall as traders await news about drug marketing and management changes.
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 PTLA
For PTLA, 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 July 20 $45 call for about $0.55 and buy a July 20 $50 call for about $0.15. This trade generates a credit of $0.40, 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 $40. The credit received when the trade is opened, $40 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $460. 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 ($40).
This trade offers a potential return of about 8.7% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if PTLA is below $45 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 $460 for this trade in PTLA.
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.