This Drug Could Help This Stock Soar
Drug trials are notoriously difficult for traders to anticipate. Both large and small companies suffer failures during testing and companies of all sizes find success. The stock market tends to quickly reward success and also quickly sells shares of companies that fail to find success.
Traders, of course, can make money whether stock prices move up or down, especially when the price moves quickly. Because the rewards are so significant, many hedge funds and institutional investors research drug trials and trade on expected results.
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For individuals, this might not be the most practical strategy. Understanding the drug trials requires specific expertise. Researching the course of trials also requires specific expertise and a great deal of time.
While the expertise and time required for this type of trading can be beyond the expertise of many individual investors, individuals can still benefit from the price moves stocks make based on news of drug trials. One recent example is in Tesaro, Inc. (Nasdaq: TSRO).
The headline shows the level of expertise that can be required to evaluate the news:
TESARO Announces Expansion to Second Stage of JASPER Trial of ZEJULA® in Combination With TSR-042 in Non-Small Cell Lung Cancer
The important points form the news release is all evaluable patients experienced tumor shrinkage and the protocol defined response criteria was achieved and a trial expansion is now ongoing. This all means that the drug worked as expected and the company is expanding testing.
In the news release, the company said it has “initiated the second stage of the JASPER study that is designed to assess clinical benefit of ZEJULA® in combination with an anti-PD-1 antibody in first-line non-small cell lung cancer (NSCLC) patients.”
The decision to advance the trial was based on achieving the protocol defined response criteria in the initial cohort of 16 treated patients with high PD-L1 expression, of which 14 were evaluable for a response. Nine of the 14 patients had objective responses by RECIST criteria at the time of the analysis1; with all 14 patients experiencing tumor shrinkage.
“These JASPER data provide preliminary evidence that the combination of ZEJULA and an anti-PD-1 antibody could be active as a first-line treatment for patients with non-small cell lung cancer and high levels of PD-L1 expression,” said Mary Lynne Hedley, Ph.D., President and COO of TESARO.
“In the second stage of the trial, 36 additional patients will be enrolled and treated with ZEJULA in combination with TSR-042, our anti-PD-1 antibody. TSR-042 is the foundation of our lung cancer strategy and is also being studied as a monotherapy in our GARNET trial in anti-PD-(L)1 naïve patients who have progressed on chemotherapy, and in combination with TSR-022, our anti-TIM-3 antibody, in AMBER, a study in late-line NSCLC patients that have progressed after anti-PD-(L)1 therapy.”
Rather than evaluating this technical detail, traders can also consider the stock chart.
The daily chart shows that the stock jumped on the news.
The weekly charts shows that this up move could be the reversal of an extended down trend in the stock. TSRO has been declining for more than a year.
The decline shows the risks of the stock but the rally shows the potential. Traders may find an options strategy that limits risk to be useful.
A Trade for Short Term Bulls
As with the ownership of any stock, buying TSRO could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for TSRO
For TSRO, the September 21 options allow a trader to gain exposure to the stock.
A September 21 $40 call option can be bought for about $1.62 and the September 21 $45 call could be sold for about $0.77. This trade would cost $0.85 to open, or $85 since each contract covers 100 shares of stock.
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 $85.
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 TSRO the maximum gain is $4.15 ($45 – $40 = $5.00; $5.00 – $0.85 = $4.15). This represents $415 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $85 to open this trade.
That is a potential gain of about 388% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.