This Stock Could Quickly Catch Up to the Bear Market
The stock market has been heading lower for most of the past month or so. But some stocks have not followed the down trend as closely as some others. One example of a stock that appears to be bucking the trend, at least for the short term, is Mallinckrodt plc (NYSE: MNK).
As the chart below shows, the stock already experienced a significant down trend. In some ways, MNK already endured its own bear market.
After peaking at nearly $135 a share in March 2015, the stock dropped more than 91% as traders worried about its business operations. But, this year, the stock seemed to be on track towards a recovery.
Barron’s recently reported, “Mallinckrodt is up nearly 40% year to date, a major reversal from 2017’s pain.
Where we’re headed: More gains are in store for the stock, argues Canaccord, given a promising pipeline and better days ahead for its previously troubled multiple sclerosis franchise.
While health-care stocks have outperformed in 2018, some individual industries have been left behind, such as biotech and pharmaceuticals, with both the SPDR S&P Biotech ETF (NYSE: XBI) and SPDR S&P Pharmaceuticals ETF (NYSE: XPH) in the red.”
The article noted that those losses came despite the fact that the Health Care Select Sector SPDR (NYSE: XLV)’s more than 10% gain. Yet one formerly unloved sector, specialty pharma, has staged a recovery this year, and in the case of Mallinckrodt, Canaccord sees that strength continuing.
Things looked quite different in 2017, with Mallinckrodt off some 50% for the year. However, like some specialty drug makers, Mallinckrodt has managed to stage a turnaround, and Canaccord’s Dewey Steadman expects the good times to keep rolling.
Recently, the analyst announced that he had upgraded the shares to Buy from Hold and at the same time raised his price target to $40 from $34.
Steadman writes that his recent conversations with management left him “largely positive” on Mallinckrodt’s execution in its core business, noting that there appears to be increased stability “and, dare we say *growth*” for its multiple sclerosis drug Acthar.
Acthar is emerging from recent challenges into a “position of strength,” he argues, while competitive threats to its hypoxic respiratory failure treatment Inomax are unlikely to erode the franchise’s position.
He also believes that investors shouldn’t underestimate the pipeline, as Mallinckrodt’s docket is filled with progress on promising drugs through 2022.
In addition, he notes that the stock trades near the low end of its industry on an enterprise value to earnings before interest, taxes, depreciation and amortization basis. “With debt under control, clarity for the business and pipeline optionality, should that be the case?”
This potentially points to recent weakness as a buying opportunity. However, the chart shows that the stock is struggling at resistance and appears to have made a down side breakout.
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.
A Bear Call Spread in MNK
For MNK, we could sell a December 21 $27 call for about $1.60 and buy a December 21 $30 call for about $0.60. This trade generates a credit of $1.00, 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 $100. The credit received when the trade is opened, $100 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $200. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($100).
This trade offers a potential return of about 50% 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 MNK is below $28 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 $200 for this trade in MNK.
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.