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3 Ways to Play Biotech With Options

http://www.fool.com/investing/options/2010/12/14/3-ways-to-play-biotech-with-options.aspx

Brian Orelli
December 14, 2010

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 th