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The Perfect Trade for Volatility Junkies

By Dr. George Huang
Friday, February 5, 2010

Last week, I told you about four make-or-break biotech events coming up this month.
 
Four stocks are facing FDA decisions. An approval will be good for a quick 30% pop. A rejection could chop 50% off just as fast.
 
Now, last week, I showed you how a rejection and a huge drop in stock price could make a fantastic opportunity to profit on a quick snapback higher.
 
But what if you are a volatility junky (like me)? What if you want to play the coin flip? Every trader's inner gambler wants to find the next Vanda, the 10-bagger darling of 2009. Vanda soared from $1 to $10 in a single day after the FDA improbably approved its schizophrenia drug.
 
The key to trading these binary events successfully is to bet only when the odds are in your favor and keep the bet small. Let me show you how...
 
As of last week, Auxilium, a $1.5 billion biotech, was facing an FDA decision on its drug for hand contracture. On Wednesday, in an early decision, the FDA granted the company an approval. The stock jumped 17% on the news to $33.
 
If you had bought February 30 calls beforehand, you would have tripled your money. Of course, if the FDA had rejected the drug, you would have almost certainly lost 100% of your capital.
 
There's a better way to trade this. You can actually make money no matter which way the decision goes.
 
It's called a "reverse ratio call spread" or a "backspread." There are a couple moving parts, so bear with me...
 
If you wanted to trade a backspread on Auxilium, here's what you would have done before the FDA decision: Buy two Auxilium February 30 calls and sell short one Auxilium February 27.50 call. You would have paid $0.80 for each 30 call and collected $2.10 from the 27.50 call, for a total credit of about $0.50. You'd actually have gotten paid to put on the trade.
 
If you're confused, don't worry. Here's the important part: Your maximum loss would have been $2, which would have happened only if shares went nowhere. You would have broken even if shares only moved a little bit. And if shares went crazy – which they usually do after an FDA decision – you would have made money, no matter which direction they went. Take a look...
 
Stock Price
Return on Expiration Day
Below $27.50
$0.50 profit
$28
Breakeven
$30
$2 Loss
$32
Breakeven
$35
$3 profit
$40
$8 profit

 
If the FDA rejects the drug and shares fall below $27.50, all the calls expire worthless, and you keep the $0.50 you got for putting on the trade. It's "free" money. Better than a sharp stick in the eye.
 
If shares stick at $30, you owe $2.50 on your short 27.50 call, and your two 30 calls expire worthless. You still keep the $0.50 you got for putting on the trade, so your total loss is $2. It's not great, but with all the volatility surrounding FDA decisions, the chances are low this will happen. And your loss is limited. You can't lose more than $2.
 
If shares rocket higher... now that's where it gets interesting. First, you owe $2.50 on your short 27.50 call, but you have your $0.50 premium, so you're down $2. But for every dollar over $30 the stock climbs, you make $1. So if the stock goes to $35, you're up $3 ($5 – $2). If the stock goes to $40, you're up $8 ($10 – $2). Your upside is unlimited.
 
Here's how it actually worked out: When the approval came through on Wednesday, the 27.50 calls were worth about $5.50. The 30 calls were trading for $3.40. Closing the combination would've generated about $1.30 in profit ($3.40 + $3.40 – $5.50). Throw in the $0.50 premium received, and you would've generated about 70% on the margin requirement.
 
Obviously, if you're new to options, this isn't the strategy for you. Stick to buying good biotechs after they've been oversold on an FDA rejection – the strategy I outlined last week – and you'll still make plenty of safe money.
 
But for experienced traders who want to give this a try, here are a couple tips: Always get paid a premium. This moves the odds tremendously in your favor. If you can't set this up for a net credit (a premium), move on. There are plenty of other opportunities. Also, don't risk the rent money. Trade as many contracts as would cover your typical stock position. Don't get excited and lever up. That's when this kind of trade will blow up in your face.
Stocks with imminent FDA approval decisions, like Xenoport and Cadence, make good backspread candidates right now.
 
It takes a little extra effort. But when the numbers work out, this is one of the lowest-risk, highest-reward ways for us volatility junkies to trade.
 
Good investing,
 
George Huang




In The Daily Crux
Market Notes
Gold and silver plummet... both precious metals dive over 4% yesterday.
 
Brazil fund EWZ craters... down 6% yesterday.
 
Investors ditch euro, buy U.S. dollar... euro hits seven-month low against the greenback.
 
Earnings today... Aetna, Beazer, Simon Property, Tyson Foods.
Market Watch
Symbol Price
Change
52-Wk
S&P 500 1221.53 +1.3% +10.1%
Oil 37.77 +1.5% -2.8%
Gold 135.20 -0.1% +13.4%
Silver 27.93 +0.4% +47.9%
US-Dollar 80.67 -0.8% +8.1%
Euro 1.32 +0.6% -12.1%
Volatility 19.39 -9.2% -8.2%
Gold Stocks 564.53 +1.3% +10.6%
10-Year Yield 3.00 +1.4% -9.6%

World ETFs
Symbol Price
Change
52-Wk
USA 122.56 +1.3% +10.2%
Canada 30.44 +1.3% +13.8%
Russia 21.63 +2.3% +16.7%
India 37.73 +1.9% +20.0%
Israel 16.47 +0.9% +9.7%
Japan 10.58 +1.0% +7.4%
Singapore 13.88 +1.0% +19.2%
Taiwan 14.72 +1.6% +17.8%
S. Korea 56.56 +1.7% +22.8%
S. Africa 70.85 +3.9% +22.9%
China 45.06 +1.4% +0.1%
Lat.America 52.82 +1.4% +6.7%

Sector ETFs
Symbol Price
Change
52-Wk
Oil Service 136.18 +1.5% +14.8%
Big Pharma 64.13 +0.6% -3.3%
Internet 72.13 +0.7% +22.3%
Semis 16.03 +2.1% +28.9%
Utilities 31.21 +0.3% +1.6%
Defense 18.51 +1.3% +10.1%
Nanotech 9.99 +1.3% +0.0%
Alt. Energy 9.95 +1.4% -4.4%
Water 18.31 +1.1% +12.2%
Insurance 16.07 +1.2% +18.3%
Biotech 20.58 +1.1% +27.1%
Retail 19.65 +0.1% +28.4%
Software 24.59 +0.9% +24.1%
Big Tech 53.73 +1.0% +21.9%
Construction 12.99 +2.1% +13.3%
Media 13.57 +1.1% +25.0%
Consumer Svcs 67.26 +0.8% +23.3%
Financials 54.87 +2.4% +5.2%
Health Care 64.22 +0.7% +1.3%
Industrials 63.25 +1.6% +19.7%
Basic Mat 73.57 +1.6% +21.6%
Real Estate 55.24 +1.4% +23.8%
Transportation 91.17 +1.4% +25.6%
Telecom 22.48 +1.1% +17.1%

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