Get Paid to Wait Out the Market
By Dr. George Huang
October 3, 2008
The market's in shambles. That's probably not news to anyone. But here's something that may surprise you: One of the safest places for your money during these tumultuous times is in biotech.
Sure, the sector is down a bit. The industry's major "thermometer" – the Nasdaq biotech index (NBI) – cooled about 5% this week. But that beats the S&P 500's 7.5% drubbing.
Historically, investors flee "speculative" biotech stocks when times are rough. Not this year. While the industry hasn't posted huge gains, it is slightly in the black. That looks pretty darn good in this market.
I firmly believe biotech is an absolute, must-own asset for the next decade. Long-term investors will get rich off new technologies coming from the sector. But I understand the need to make money in the short term, too. As I've written before, there's one way to juice near-term gains while waiting for the longer-term biotech bull market to mature: options.
Options offer several ways to profit in sideways (and volatile) markets like the one we're in right now. In September, I told you how to collect solid short-term returns by shorting naked puts. Today, I'm going to share with you another one of my favorite biotech trades – writing covered calls.
When you write a covered call, you sell someone else the right to buy your shares at a higher price. And you get paid up front.
Covered call trades can work out three ways:
1. If the stock trades higher than the call option price, your shares will be "called away" – sold at that price. You keep the option premium and pocket the difference between the stock price and the call price.
2. If the stock trades sideways, you keep the option premium as a profit while continuing to own the shares.
3. If the stock trades down, the call premium can absorb the initial loss. I like to collect at least 5%-10% up front to give me a wide margin of safety.
Due to current market conditions and the biotech sector's infamous volatility, options premiums are sky high – great news for sellers. The key is finding safe stocks that won't fall in the short term. Let's take a look at a textbook case...
Back in May, I recommended a biotech called Indevus (IDEV) to my S&A FDA Report readers. The company hit a regulatory setback, and the stock lost 70% of its value in June. Based on my research, even in the worst-case scenario, Indevus was 50% undervalued. In other words, our downside risk was next to nothing.
But I knew it could take six months to a year for the shares to gain traction. So I designed a trade that paid us while we waited...
I recommended buying Indevus shares around $1.70 and selling the January 2.50 calls. Those calls gave someone else the right to buy shares from us in January for $2.50 – nearly 50% higher than the stock was trading. We got about $0.25 per share for selling that right.
We pocketed the $0.25 immediately, earning about 15% right away. If the stock fell, we had a 15% cushion. If the stock traded flat, we could've simply kept our shares. But as it turned out, Indevus reported some positive news last week that got its stock moving again... Shares shot north of $3 in one day, a 90% jump.
So my readers will likely have their shares called away in January at $2.50. We'll make $0.80 in capital gains, plus the $0.25 in premium. That gives us a whopping 70% gain in just six months.
If you're looking for big returns in biotech, you're probably not going to get it holding an ETF right now... not with the market behaving the way it is. A better bet is selling covered calls on high-quality, beaten-down stocks. And the best part: You get paid to wait.
Good investing,
George Huang
