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 with 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
Last year, Orexigen Therapeutics 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' Qnexa and Arena Pharmaceuticals' lorcaserin were previously shot down, 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*||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.
*Calls control 100 shares.
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.
1-Day Price Change
||95%||Positive phase 3 trial results|
||46%||Selected for procurement of smallpox antiviral for the Strategic National Stockpile|
||27%||Patent extension for its multiple sclerosis drug|
Sources: 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. Dendreon
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. 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 Regeneron Pharmaceuticals
|Bull Call Spread||$49-$50||$50-$55||$55-$60||$60-$65|
|% Chance Shares Will Exceed the Upper Strike Price||75%||69%||42%||24%|
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 after the FDA advisory panel meets on Friday. Just divide the cost by the potential return to get an idea of the likelihood investors assign to the shares exceeding that level.
In this case, it looks like investors think there's a slight chance Regeneron's shares fall a little after the meeting. If the committee gives a ringing endorsement, there's some upside, but a jump of more than 10% looks like a long shot.
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This article was originally published Dec. 14, 2010. It has been updated.
Fool contributor Brian Orelli doesn't own shares of any companies mentioned. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.
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