3 Ways to Play Biotech With Options

Biotech is synonymous with risky. Options are considered risky. So biotech plus options must equal risky squared!

Either you're a masochist, or you clicked on the headline looking for a way for options to help you decrease that risk. I can only hope the latter's true.

Missing the point
Options can be more dangerous than stocks. Because they can expire worthless, there's frequently an all-or-nothing aspect to the investment.

Consider the possible outcomes of a $10,000 investment in shares, compared to call options:

Security

Amount invested

Gain (Loss) If Shares Are At $4 at Expiration

Gain (Loss) If Shares Are At $3 at Expiration

Gain (Loss) If Shares Are At $2 at Expiration

Shares purchased at $5 $10,000 ($2,000) ($4,000) ($6,000)
Call $5 strike $10,000 ($10,000) ($10,000) ($10,000)

But why do we have to invest the same amount of money in more peril-fraught options? Instead, we could simply invest a smaller amount of money there:

Security

Amount invested

Gain (Loss) If Shares Are At $4 at Expiration

Gain (Loss) If Shares Are At $3 at Expiration

Gain (Loss) If Shares Are At $2 at Expiration

Shares purchased at $5 $10,000 ($2,000) ($4,000) ($6,000)
Call $5 strike $2,000 ($2,000) ($2,000) ($2,000)

Ahh, that's better. We've capped our maximum loss with options, which is less risky than investing a larger amount in shares.

I know what you're thinking: "You've invested less, so you've just lowered your upside potential!" Well, maybe not.

A real-life example
Orexigen Therapeutics
(Nasdaq: OREX  ) recently went through a Food and Drug Administration advisory panel for its obesity drug Contrave -- a binary-outcome event if I've ever seen one.

After VIVUS's (Nasdaq: VVUS  ) Qnexa and Arena Pharmaceuticals' (Nasdaq: ARNA  ) lorcaserin both got shot down earlier this year, it seemed likely that the panel of outside experts would go three for three.

The day before the panel, Orexigen shares ended the day at $4.87. The company had $2.11 in cash and short-term securities. Since we could consider $2.76 as our potential max loss on a stock investment, we'll bet an equivalent amount on options: for every $4.87 of shares, we'll buy $2.76 of calls.

As it turns out, the panel gave a positive recommendation. The smaller bet wasn't necessary. Shares zoomed up. Since few were expecting the positive panel, the calls soared even higher.

Security

Amount invested

Price per share controlled

Number of shares controlled (calls control 100 shares)

Price After Positive Panel

Value After Positive Panel

Total Gain

Shares purchased at $4.87 $4,870 $4.87 1,000 $8.77 $8,770 $3,900
Call $5 strike $2,760 $1.35 2,044 $3.80 $7,767 $5,007

Source: Yahoo! Finance.

If you assume the cash on hand was as far as the shares could have fallen, you've risked the same amount, but made a numerically higher gain using options.

Protecting those profits
Sometimes, you get that hit. And when biotechs hit, they hit big.

Company

1-Day Price Change

Reason

AVANIR Pharmaceuticals (Nasdaq: AVNR  ) 98% FDA approval of Nuedexta
Momenta Pharmaceuticals (Nasdaq: MNTA  ) 82% FDA approval of its generic version of sanofi-aventis' Lovenox
Exelixis (Nasdaq: EXEL  ) 32% Positive data on cancer drug candidate XL184

Source: Yahoo! Finance and company releases.

But pricing biotechs is often more art than science. After shares zip upward like that, they could go higher -- but they could also pull back, as investors realize they're a little too excited about the company's prospects.

Holding the shares and buying a put allows you to take advantage of any further gain without having to worry about the stock going down, as happened to both AVANIR and Momenta post-FDA approval. If the shares retreat, the increase in the put cancels out the loss on the shares.

A put isn't free. And if it's really expensive -- if, for instance, there's another upcoming binary event that investors think could push the price down -- you might be better off just selling, rather than buying the protection. But it's a nice option to check before you hit that "sell" button.

Look, but don't touch
Still not convinced that options are for you? Fair enough. But don't throw out the idea of looking at options prices before you buy the underlying stock. They can be helpful for telling you where a stock is potentially going.

The easiest way to see this involves a bull call spread for potential increases, or a bear put spread for potential decreases. You can read more about the idea here, but here's the short version: In a bull call spread, you buy a call at one strike price, and sell a call at a higher strike price. The maximum value at expiration is the value between the two strike prices.

Here's another real life example: Let's say we want to know the potential price after Human Genome Sciences (Nasdaq: HGSI  ) hears back from the FDA about its lupus drug Benlysta in March. With the stock recently trading around $25, here's where the April calls traded.

Bull Call Spread $25-$26 $28-$29 $30-$31 $33-$35 $35-$40
Price $0.50 $0.38 $0.30 $0.27 0.36
Maximum Profit $1 $1 $1 $2 $5
% Chance Shares Will Exceed the Upper Strike Price 50% 38% 30% 13.5% 7.2%

Source: Yahoo! Finance. Prices represent the midpoint between the bid and ask price.

Even if you don't want to buy a call or a bull call spread, you can use the option prices to get an idea of where investors think the stock will settle if the FDA gives Benlysta a thumbs-up. In this case, it looks like investors think that price will land somewhere between $31 and $33. If you're looking for a double from this stock, an FDA approval for Benlysta alone won't get you there.

Thirsty for more?
Our Motley Fool Options newsletter is filled with ideas on how to boost your returns and hedge your risk using options. If you're interested in diving a little farther into this subject, enter your email in the box below, and we'll send you a free copy of our options trading guide, Options Edge 2011.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of (nor option in) any company mentioned in this article. Exelixis and Momenta Pharmaceuticals are Motley Fool Rule Breakers recommendations. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool owns shares of Exelixis and has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 14, 2010, at 3:00 PM, icantknow wrote:

    On the biotech, it is wierd how a company like VVUS went up, when OREX got the FDA Advisory panel approval 13-9... I recall that at the end of that OREX panel, 2 of the members said they were going to vote no before voting yes after a post-marketing research question. My point is, this could have been an 11-11 by a hair. And that was the same comment made by the panel a few times how Orexigen research made it by a hair for one of the two requirements. (I'm pretty sure of my comment validity, but don't take my word for it)... VVUS and ARNA were told to go back to the research by the FDA. ARNA tanked after that, and VVUS is rallying. Why this is I do not know. Sure their is enthusiasm with OREX squaking by the Advisory Committee, but VVUS has a long way to go, and it seems quite risky. I've seen 3 analyst announcements - and they are all completely different.

    Can anyone explain why the market continues to support VVUS at the $ 9 (ish) price, when it was a $ 6-7 stock until last week?

    Thanks!

  • Report this Comment On December 14, 2010, at 3:03 PM, icantknow wrote:

    sorry "there is enthusiasm" from the market. Wrong spelling. icantknow about some things, but I try to know english!!

  • Report this Comment On December 14, 2010, at 5:57 PM, TMFBiologyFool wrote:

    icantknow,

    A good user name if you're investing in obesity drugs. Figuring out what the FDA will do with OREX and VVUS got a lot harder after the advisory panel voted in favor (although as you point out, not by much) Contrave. Before that it looked like there was a slim to none chance of approval, which increased post-panel.

    But you're right that the chance of a approval is still a bit of a block box. If you tried to buy a straddle (put and call) on the stock it would cost an exorbitant amount. That's the market saying we don't know which way it'll go.

    ARNA remains down because proving the lack of cancer is difficult. Until investors are convinced the FDA is satisfied, it's going to remain down.

  • Report this Comment On December 14, 2010, at 7:02 PM, TMFBreakerTAllan wrote:

    Great options update. But don't forget that you can employ a covered call strategy pre-approval for these stocks. Buy the stock well in advance of approval and start selling calls monthly before the FDA decision. And then sell ITM money calls for the expiration prior to the expected decision date.

    I have found that I can make money selling the volatility and usually get out of the position pre-decision date, making money off the speculators on the stock movement.

    T. Allan

    RB Home Fool

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