Friday, September 19, 2008
Biotech is in limbo... but that doesn't mean we can't make money trading the sector right now.
Last month, I told my readers a new biotech bull market had just begun. I still believe that's true. But the sector will trade sideways for a few more weeks. Here's why...
Right now, biotech's biggest investors are waiting for payouts from three pending megamergers: Roche/Genentech, Bristol-Myers/ImClone, and King/Alpharma. In all three cases, the boards of the take-out targets have rejected the bids as too low. And all three stocks are trading at or above the offer price, meaning the market believes higher bids are coming.
While the acquisitions will eventually result in a $50 billion windfall for shareholders, the deals must finalize before money will flow freely through the rest of the sector. Mutual funds, exchanged-traded funds (ETFs), and hedge funds are waiting to get paid before rotating money into new biotech names.
So if we're looking for solid returns in the short term, holding a biotech ETF is not going to do it. Going long gets us nowhere for the next few months. Instead, we need to turn to the options market...
Options offer several ways to profit from a sideways market. My favorite strategy is "shorting naked puts."
That might sound complicated... and risky. But as I'll show you, shorting naked puts is pretty straightforward, and it actually gives you a bigger margin of safety than simply owning a stock.
When you short a naked put, you're selling a put option on a stock you don't own. In other words, you get paid upfront for agreeing to buy a stock at a specified price at some point in the future. If the stock declines, then you buy it at the bargain-basement price. If the stock trades sideways or up, you keep the option premium as a profit.
Selling naked puts is a fantastic way to profit in biotech. In no other sector are option premiums higher. Let me explain...
Option premiums are based on the volatility of the underlying stock. Biotech is the most volatile sector on Wall Street. So you can collect boatloads of cash selling put options on top-quality biotech stocks. If you know where to look for safe opportunities, it's practically free money.
For example, I recommended a biotech company called Theravance (THRX) to my S&A FDA Report readers back in May. Based on a short-term setback, the stock had lost 65% of its value in just six months. I knew Theravance was cheap, so our risk was limited.
But I also knew the stock was going to take a while to rebound. So I recommended selling the 12.50 puts for $1.75. In other words, we were obligated to buy 100 shares at $12.50 if the stock dropped. For agreeing to that, we collected $175.
Three months later, the stock was still above $12.50. So we closed the trade out by buying back the put for less than $0.25. We pocketed a $150 premium. In short, the market was handing out free money while we waited for our long-term investment thesis to play out.
Tons of opportunities just like this litter the biotech landscape today. If you're looking to sell naked puts in the biotech sector, don't gravitate toward names with high options premiums. Those are the riskiest bets. Instead, look for high-quality, mid- to large-cap names with products on the market and cash in the bank.
That should keep gains rolling in while we wait for biotech to take off.
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