Traders Can’t Decide Whether to Buy or Sell This Stock
News often creates volatility in a stock’s price. But, the volatility is almost always in one direction. But, not always as Global Blood Therapeutics, Inc. (Nasdaq: GBT) demonstrated recently.
The company announced that late stage trial results for its sickle cell disease therapy were mostly positive.
According to MarketWatch, “patients on the therapy, called voxelotor, showed a statistically significant improvement on the trial’s primary endpoint, measuring an increase in the oxygen-transporting protein hemoglobin, compared with the placebo.
And a majority of patients — 58% — on the higher dose of voxelotor demonstrated an increase in hemoglobin after 12 weeks of treatment, relative to 9% of patients on the placebo. That’s also better than a 35% response rate that the company had discussed with the Food and Drug Administration.
Those results came from Part A of the of the phase 3 HOPE study, which stands for Hemoglobin Oxygen Affinity Modulation to Inhibit HbS PolymErization.”
Sickle cell anemia is an inherited condition that causes patients’ red blood cells to become shaped like sickles, preventing blood flow and causing painful attacks, fatigue, organ damage, stroke and more. The rare disease affects predominantly African-Americans in the U.S., and there are few treatment options.
Based on the results, the company decided to pursue an accelerated approval process for the drug. The company’s CEO, Ted Love, noted, “We know that the outcomes for sickle cell patients are terrible. They will ultimately lose their organs and they will ultimately die, about three decades earlier than they should.”
Based on the risks of the disease, he believes the company’s results should be enough for an initial approval. Traders are not as confident.
Volatility Follows the Decision
The stock moved wildly in reaction to the news. The day before the announcement, the stock closed at $38.70. It gapped down at the open the day of the announcement and traded as low as $33.80 and as high as $49.25.
The day’s range is equal to about 40% of the previous day’s close, an unusually wide range. The volatility is especially noteworthy given that the stock’s low was more than 12% below the previous close and the high was more than 27% above the close.
The downside risk is that if the FDA doesn’t approve voxelotor, the company’s decision could cause a delay in the testing process.
But, the upside potential is significant. The company believes sales could ramp up to approximately $500 billion fairly quickly.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in GBT 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 GBT
The bearish outlook for GBT, 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 July 20 $45 put can be bought for about $3.10 and the July 20 $40 put can be sold for about $1.40. This trade will cost about $1.70 to enter, or $170 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 $170. This loss would be experienced if GBT is above $45 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 GBT, the maximum gain is $3.30 ($45 – $40 = $5.00; $5.00 – $1.70 = $3.30). This represents $330 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $170 to open this trade.
That is a potential gain of about 94% of the amount risked in the trade. This trade delivers the maximum gain if GBT closes below $40 on July 20 when the options expire.
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 $170 for this trade in GBT.