Trading pharmaceutical stocks: Take the Red Pill, the Green Pill, or both?
Traders tend to like pharmaceutical stocks because there is more than a little volatility in the sector, which means stock prices can make erratic moves both up and down. Many times movement in pharma stocks can be particularly pronounced given a company’s binary dependence on new products: a trial for a new drug is approved, or it’s not; the new drug works, or it doesn’t; regulatory approval to manufacture and distribute the new drug is granted, or it’s not; the insurance companies offer coverage of the medication, or they don’t. The news is good, or it’s bad.
Many times it’s about as black-and-white as it can get in the financial markets. A scene similar to this has arguably been playing out with Valeant Pharmaceuticals (NYSE: VRX):
Source: OptionsHouse by E*TRADE
Valeant is an international company based out of Quebec, Canada that develops and manufactures a broad range of pharmaceutical products. For some time VRX has been at the center of a controversy around drug prices,1 coupled with financial issues and potential lawsuits,2 while its stock price bounced wildly. Hence a stock chart that looks like a Jack O’ Lantern’s crooked grin amid a broader market that has continued to hit new highs.
On Tuesday morning, options traders took a position to try to profit from the volatility of VRX stock.
- Traders bought 5,000 VRX December 13 calls for $1.14.
- They concurrently bought 5,000 VRX December 13 puts for $1.19.
- Taken together, the net position is long a Dec 13 straddle for $2.33 ($1.14 + $1.19).
By owning the Dec 13 straddle, they have the right to buy or sell VRX shares at $13 per share on or before December expiration. The risk/reward options graph for this position looks like this:
Source: OptionsHouse by E*TRADE
The traders who bought this straddle are looking for VRX to make a move up or down away from $13 before the December expiry. They can’t predict the unpredictable, and they don’t know whether the stock is going up or down, but they do expect the stock to move more than $2.33 (the amount they paid for the straddle) away from $13. To make a profit, they need the stock to drop below $10.67 ($13.00 - $2.33) or climb above $15.33 ($13.00 + $2.33). In the chart above, those profit zones are represented by where the red turns green on either side.
VRX reports earnings on November 7, before expiration. That does add an additional uncertainty event that could benefit the straddle owners. The lesson from this particular strategy is that there can be different ways to trade the markets. In this particular case it isn’t about being either bearish or bullish, but rather it’s about your conviction that something is going to happen, even if you’re not sure what it’s going to be.
1. Morgensen, Gretchen. "How Valeant Cashed In Twice on Higher Drug Prices," The New York Times, 29 Jul. 2017. https://www.nytimes.com/2016/07/31/business/how-valeant-cashed-in-twice-on-higher-drug-prices.html?_r=0
2. Levisohn, Ben. "Valeant: A Problem...Or Just More Noise," Barron's, 13 Oct. 2017. http://www.barrons.com/articles/why-valeant-is-dropping-1507913812