Triple Digit Income in a World Where Income Is Scarce
Trade summary: A bear call spread in Emergent BioSolutions Inc. (NYSE: EBS) using June $65 call options for about $7 and buy a June $70 call for about $4.40. This trade generates a credit of $2.60, 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 $240. 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 ($260). This trade offers a potential return of about 108% of the amount risked.
Now, let’s look at the details.
Income investors are starved for yield. A company that lost an important patent dispute could be the answer for aggressive income investors.
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EBS, according to ZACKS, announced that “a district court of New Jersey passed an unfavorable decision with respect to the company on the patent litigation of its Narcan (naloxone HCl) nasal spray 4mg. The court ruled in favor of the defendants, Teva Pharmaceuticals Industries Limited.
Emergent plans to appeal the above decision to the Court of Appeals for the Federal Circuit.
Per the press release, the financial outlook for 2020 that includes expectations related to this litigation, efforts to develop and manufacture the COVID-19 vaccines and therapeutics, and other relevant information will be provided when Emergent reports second-quarter 2020 financial results.”
Narcan is a medication used to block the effects of opioids. It is commonly used to counter decreased breathing in opioid overdose. Naloxone may also be combined with an opioid (in the same pill), to decrease the risk of opioid misuse.
When given intravenously, effects begin within two minutes, and when injected into a muscle within five minutes. Another route it can be given is by spraying it into a person’s nose. The effects of naloxone last from about half an hour to an hour. Multiple doses may be required, as the duration of action of most opioids is greater than that of naloxone.
While Narcan is useful, and an important medication, it is an important part of the financial success of EBS. As GlobeNewswire reported,
“We are understandably disappointed by the decision today,” said Doug White, senior vice president and devices business unit head at Emergent BioSolutions. “We remain committed to expanding awareness, maintaining affordability, and increasing access to NARCAN® Nasal Spray, to improving public health, and to assisting those dedicated to ending the opioid crisis.”
The stock was down on the news.
But EBS had been moving higher on hops that the company would deliver a COVID-19 vaccine. That pushed the stock out of a trading range that can be seen on the weekly chart.
Without reliable revenue from Narcan, EBS is now a high risk stock and that sets up a potential income trade.
Shorting shares of the stock 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 EBS
For EBS, we could sell a June $65 call for about $7 and buy a June $70 call for about $4.40. This trade generates a credit of $2.60, 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 $260. The credit received when the trade is opened, $260 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $240. 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 ($260).
This trade offers a potential return of about 108% 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 EBS is below $65 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 $240 for this trade in EBS.
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.