Trading Big Gains, After the Big Gain
Source: Loxo Oncology
For traders, the problem is well understood. The goal is to own stocks that make big moves. But, what’s the right trade after the stock makes a big move? In other words, the problem is whether to trade a stock after it makes a one day, double digit gain.
Although it might be surprising, there is a precise answer to this question in certain circumstances. There is a straightforward answer to stocks in the biotech sector.
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Big Gains on News About a Cancer Drug
An experimental Loxo Oncology Inc (Nasdaq: LOXO) drug that targets cancers with mistakes in the RET gene led to tumor shrinkage in nearly 70% of patients regardless of where their cancer originated, according to preliminary data from a small study released on Wednesday.
The drug, LOXO-292, was well tolerated by patients with advanced cancer, many of whom were resistant to or no longer being helped by available treatments, researchers reported.
The oral medicine is intended for cancer patients with RET abnormalities in which two genes become fused together, triggering accelerated cancer cell growth.
RET fusions, an acquired rather than inherited gene defect, occur in about 2% of lung cancers, 10% to 20% of papillary thyroid cancers, and a small number of other cancers. Other mutations known as activating RET point mutations account for about 60% of medullary thyroid cancers, which comprise 3% of all thyroid cancers.
As of the cutoff date of January 5, data included 35 patients with RET fusion positive tumors, including 27 with non-small cell lung cancer (NSCLC), 7 with papillary thyroid cancer and 1 with pancreatic cancer. Another 20 patients had medullary thyroid cancers with RET point mutations.
In RET fusion positive patients, 69% of those who could be evaluated had significant tumor shrinkage, based on standard criteria for overall responses, typically shrinkage by at least a third.
The overall response rate was 65% for those with NSCLC, including three whose cancer had spread to the brain, and 83% for patients with papillary thyroid cancer.
In patients with medullary thyroid cancers, some 79% experienced tumor shrinkage ranging from 9 to 45%.
A brief summary of the results was released on Wednesday ahead of next month’s American Society of Clinical Oncology Meeting Chicago, where more detailed data on the study involving more patients will be presented.
Analysts and Traders Respond to the News
According to MarketWatch, “The results were impressive, with apparently “unremarkable” safety data, said Stifel analyst Stephen D. Willey, who now expects peak U.S. sales for the drug of more than $800 million. The abstract’s results cover the clinical trial through January 2018, but the ASCO presentation will cover the trial through April 2018, and “the efficacy data have improved between the January and April data cut-off dates,” the company noted.”
The stock’s jumped more than 20% on the news.
This continues the long term up trend that has been in place for months.
In a test on biotech stocks showing large one day gains using data back to 1982, most of the stocks pulled back slightly but maintained a majority of their gains. This information pointed towards a trading strategy in LOXO.
There is a chance the stock could move up over the next month, but the odds favor a pullback. Selling a put can benefit from this strategy because the large price move has created attractive opportunities for put sellers. Using a put at least 20% below the current market price minimizes the risks since pricing models indicate a 90% probability of success. A spread reduces the risk even more.
Trading the Trend
When a stock is expected to move higher or pull back slightly, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for LOXO
For LOXO, a bull put spread could be opened with the June 15 put options. This trade can be opened by selling the June 15 $125 put option for about $1.35 and buying the June 15 $120 put for about $0.95.
This trade would result in a credit of $0.40, or $40 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($125 – $120). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $460 ($500 – $40).
The potential gain is about 8.7% of the amount of capital risked. This trade will be for about one month and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.