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When big pharma sees value, join ‘em
Kevin Cook is an options instructor for the Options News Network. He was an institutional foreign exchange market maker and arbitrageur for nine years, where he worked with futures. October 2, 2009 7:35 EDT Related Symbols: AMGN, IBB, MRK, PFE, TEVA
The Biotech ETFs
In March, I recommended a long position in the biotech sector through the purchase of the iShares Nasdaq Biotech ETF (IBB). With equity values galore at that time, I saw this opportunity to “own the future” as a no-brainer for investors with a five-year horizon.
The IBB has been a steady gainer, especially with all the M&A activity in the space (see list below) as giant biopharma companies see value everywhere and continue to scoop up competitors, partners, and fledgling biotech companies.
Research issued last week from ReportLinker on “The Evolving Pharma M&A Landscape” highlighted the trend:
“The world’s ten biggest pharmaceutical companies have committed almost $230bn to M&A deals since the beginning of 2007. The size of their assets and the cash-generating capabilities of their existing businesses have rendered them largely immune from the effects of the global economic downturn, during which big pharma M&A spending has actually accelerated. Key M&A announcements will continue to be made on a regular basis into 2010 and beyond.”
And with healthcare stocks even more in the limelight as Obama and Congress battle over the politics, this sector will see continued volatility. That’s why on July 24th, I recommended a long September 70/80 strangle in the IBB to protect gains and profit from further upside. That trade was profitable, with the IBB rallying to new 52-week highs near $83 by September options expiration.
The IBB took a big hit on Thursday with the broad market, down nearly $2 or 2.4% at the close and falling another 50 cents to below $79 in after-hours trading. So I am looking for opportunities to sell volatility and play the possible trading range I see developing between $70 and $85 over the next quarter. Before I look at some of the potential option plays, let me run through a quick hit list of the M&A action—and potential deals—we’ve seen in this space this year:
I’m likely missing a big deal or two here, but you get the idea. Now let’s look at how to play options on the IBB. Why not options on individual biopharma names? Because with the two huge drivers of huge price volatility—drug discoveries/flops (approvals/denials by the FDA, essentially) and takeovers—biopharma stocks and smaller biotech stocks tend to trade like lottery tickets. In other words, they have risk/reward payoffs that resemble all-or-nothing windfalls.
A great example this year would be Human Genome, which fell to 50-cents a share in March and then launched back into the teens this summer on good news about its lupus drug Benlysta, and a possible takeover by Glaxo. This is what I mean by lottery type payoffs in the world of biotech.
That means their option volatilities and thus their option prices are high. Fortunes are made on the 1 winner in 100 you are lucky or smart enough to find. But you never sell short that volatility, like I do with the IBB ETF.
My premise is the same as the one used for my XLE iron condor and short strangle strategies. I want to “buy and trade” a stable basket of quality stocks like the IBB under most economic environments. It’s top five holdings are Amgen (AMGN), Gilead Sciences (GILD), Teva Pharmaceuticals (TEVA), Celgene (CELG), and Vertex (VRTX)—all stocks I want to have exposure to individually or through this sector ETF. Then I want to sell covered calls and cash-secured puts in a trading range around the lower volatility of the ETF.
The Short Strangle
Here was the IBB short strangle I recommended in early September from my column “Buy Extreme Pessimism, Sell Extreme Optimism:”
“The IBB traded in a range between $60 and $70 for four months and offered lots of opportunity to sell premium. Now that it has launched into the high $70s, I see plenty more opportunities. I would be selling the Oct 70 put for $0.50 and the Oct 80 call for $1.25.”
Collecting $1.75 for this strangle against a core long position in the IBB gave me a chance to be assigned on the short call and have my shares called away at $80 (an effective sale price of $81.75) and to buy more shares upon assignment of the $70 put at an effective price of $68.25. Since the IBB ran up to $84.00 and has now dropped back below $80, I would love to have had my shares called away. But I am still happy owning them and having the extra premium income as a cushion to that position.
The Oct 70/80 strangle is trading for about $1.00 as of Thursday’s close and I could buy it back for half of that very soon if the market continues to fall, or I could just let the trade decay to expiration and see if my shares get called away on another rally above $80. In either case, I also get to repeat the strategy in November and December options.
Based on my expected range for the IBB between $70 and $85, we can construct many different ways to sell out-of-the-money calls and puts that add income to a core long IBB strategy. For instance, if we want to sell near-term options into the middle of the fourth quarter, we could sell the November 75/80 strangle for about $3.40. Buying the IBB between $75 and $80 and collecting $3.40 for the short 75/80 strangle gives me an effective sale price of $83.40 if the shares are called away and effective purchase of more shares at $71.60 if the short put is assigned.
Thursday closing prices, with the IBB around $79.50, had the Nov 75 put rising 55 cents to $1.40 and the Nov call falling $1.27 to just above $2.00. The 80 calls got hit hard with implied volatility dropping to 21%, while implied volatility on the 75 puts climbed near 26%. Historical volatility (the actual volatility of the IBB itself) has fallen from above 40% to 15% since April and the implied volatility of the options had dropped from near 40% to just above 20%. With the broad market sell-off, these vols will likely rise and better opportunities will surely come.
The opportunity now may be to focus on selling covered calls against a core holding of the IBB. Then, as the ETF approaches $70, selling cash-secured puts (at the November or December 70 strike) will provide the most income on an absolute basis because of the delta of the puts (that is, how close to being in-the-money they are) and how much implied volatility has risen and is reflected in the premium of those puts.
Next week, I will look at iron condor opportunities in the IBB. The iron condor is a strategy where you sell two out-of-the-money spreads, a bear call spread and a bull put spread. It’s a more conservative way to sell options because you don’t need to own the underlying to sell the call spread, nor tie up capital in your account to secure a short put. You can learn more about how I’ve done this with the XLE energy sector ETF in my article "XLE Iron Condors and Short Strangles."
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