This Overbought Drug Stock Could Generate Income of 56%
Trade summary: A bear call spread in Inovio Pharmaceuticals, Inc. (Nasdaq: INO) using July $25 call options for about $6.40 and buy a July $30 call for about $4.60. This trade generates a credit of $1.80, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $320. The risk can be 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 ($180). This trade offers a potential return of about 56% of the amount risked.
Now, let’s look at the details.
There were several recent analyst reports on INO according to Benzinga. The reports come after the stock more than doubled in a month.
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The surge in price could have been caused by a $71-million DoD contract award for its COVID-19 vaccine delivery device.
In one report, “H.C. Wainwright analyst Raghuram Selvaraju downgraded Inovio from Buy to Neutral and removed the price target.
The Inovio Thesis: Inovio shares have risen 746.9% since Jan. 23, when it announced initial CEPI funding for its DNA vaccine against the novel coronavirus, compared to a mere 18.4% rise by the SPDR S&P Biotech (NYSE: XBI), Selvaraju said in a Monday note.
Inovio’s COVID-19 vaccine candidate INO-4800 is now valued by the market at roughly $4 billion, the analyst said.
“We believe the risk/reward ratio for Inovio has increased significantly as many open questions remain, including the strength and duration of neutralizing antibodies and T cell responses that may be generated in human trials and the effective protection the vaccine may demonstrate in animal challenge studies.”
The skepticism is primarily due to the fact that there is no approved human vaccine for any type of coronavirus and that no DNA vaccines have been approved yet for human use, he said.
Selvaraju did not rule out upside from current levels. Any potential upside, hinges on the following, the analyst said:
- Positive clinical data from human and animal challenge studies
- Evidence that the immunity lasts sufficiently
- Superiority of the DNA vaccine to competing vaccination approaches
- Inovio’s ability to obtain market authorization, supply its vaccine sustainably and at an affordable price, while also enabling a reasonable profit margin
- Long-term persistence of the pandemic itself
H.C. Wainwright noted that the interim Phase 1 readout of the DNA vaccine is due this month, with Phase 2/3 studies likely to start in summer.”
That could create volatility and the stock price is elevated. It’s possible INO could sell off even if there is good news from the study.
Shorting shares of the stock to benefit from potential declines exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for INO
For INO, we could sell a July $25 call for about $6.40 and buy a July $30 call for about $4.60. This trade generates a credit of $1.80, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $180. The credit received when the trade is opened, $180 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $320. The risk can be 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 ($180).
This trade offers a potential return of about 56% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if INO is below $25 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 $320 for this trade in INO.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.