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One
of our members wrote a bear call spread on OSI Pharmaceuticals
(OSIP) a couple of days before December 17th option
expiration. A bear call spread is a credit spread created
by selling a call and simultaneously buying a higher-strike
call on the same stock with the same expiration. The long
and short calls create a spread, and since the trader
pays less for the higher-strike than is received for selling
the lower strike, the trade generates a net credit upon
entry. This spread is a neutral to bearish trade,
meaning that it wins if the stock falls in price or at
least stays below the lower strike sold. Thus maximum
profit is realized when the stock closes below the short
strike. The maximum possible loss will be realized if
the stock closes above the higher strike bought. OSIP's
price exploded the evening of December 16th, and by the
open on December 17th had gapped up over $20, handing
the member the maximum possible loss.
How
did it happen? The impetus for OSIP's gap up came from
left field - sort of - when AstraZeneca announced
that a trial of its Iressa drug showed the drug failed
to significantly prolong survival in lung cancer patients.
Obviously, this worked no good for AstraZeneca's stock
price. As it happens, OSIP and Genentech (DNA) are jointly
developing a drug (Tarceva) for the treatment of non-small
cell lung cancer and had received approval of Tarceva
from the Food and Drug Administration on November 19th.
AstraZeneca's loss was their gain.
But...
OSIP and DNA did not equally share the good vibes from
Astra Zeneca's loss. Though OSIP and DNA were trading
at roughly the same price when the Iressa news occurred,
OSIP shot up over $20, yet DNA gained only a paltry $2.87.
The question is, were there any warning signs that would
have kept a trader out of an OSIP bear call spread?
| 1. |
OSIP
is Historically Volatile. As the
chart below shows, this stock is volatile by any
measure, a prime warning sign. In April it gapped
up from $39 to almost $100. It's just one of those
stocks. It is a stock that could rightfully make
a covered call writer nervous, but it is truly dangerous
for a credit spread writer. Despite periods when
it trades like most stocks, it will without warning
react wildly and way out of proportion to news.
Can credit spreads be written successfully on such
a stock? Yes, but when a volatile stock does its
thing, it will hand you the maximum possible loss
on the spread, and quickly. I thought OSIP was more
than fully valued at $48 or so before the gap up.
But that is what volatile stocks do.
Analysis of the
MACD, RSI or any other indicator before the gap
up would have been a waste of time on OSIP. Put
differently, they would not have saved this trader.
Technical indicators cannot remotely predict volatility.
Note also that its volume is flaky. Its average
volume is currently running well over 2 million
shares daily, but taking a few high-volume days
out of the average, it usually trades well under
1 million shares daily. |
| 2. |
The
Company Loses Money. Companies
that are unprofitable tend to be more volatile and
more easily manipulated, except for very large-cap,
stable companies currently in a slump. Plus, when
the going gets tough, the money losers tend to get
knocked down first and stay down longest. I don't
often pick unprofitable companies for covered calls.
A good argument can be made that the unprofitable
ones are good for bear call spread trades, and that
is true to an extent - just not when they're in
the pharmaceutical industry and this volatile. |
| 3. |
OSIP
is a Pharmaceutical Stock. As obvious
as that observation is, the fact is that pharmaceutical
stocks are as a class among the most volatile of
stocks. And the smaller the company, the more meaningful
any news about itself or a competitor will be -
and the more volatile it will be. The major drug
companies are more stable, and seldom appear on
CallWriter's Real Time Lists™ - simply because
the market knows that run-of-the-mill study results
and FDA rulings will not normally move the stock
very much. But the smaller the company (ex: poor
little unprofitable OSIP), the more significant
any news will be in light of its size. Pharmaceuticals
frequently hit our lists precisely because major
news - major in the context of the company's size
and prospects - is coming.
Writing covered
calls or spreads on them can be done successfully,
but it requires a lot of work and patience. It is
absolutely crucial to do the proper research, as
explained in the following two points. |
| 4. |
Premium
is High for a Reason. Whenever
a stock is paying high premium, it is because implied
volatility (IV) is high. That is, the market is
willing to pay more for options on the stock because
it thinks the stock is more likely than others to
move on impending news. The high premium implies
high volatility. Now, high IV in and of itself does
NOT mean that the stock will be more volatile than
other stocks, just that the market thinks it might.
So when market opinion
causes premium to be high, a trader should find
out WHY it is high. Which brings us to the next
point... |
| 5. |
Look
for the News. I went back and looked
for news prior to OSIP's gap up and found nothing
- about OSIP. However, those who avidly follow OSIP,
or pharmaceuticals in general, knew that AstraZeneca
would be releasing results on its Iressa lung cancer
drug, and also knew that poor news would probably
boost competitors DNA and OSIP, which had already
gotten positive news on their own Tarceva lung cancer
drug. This is why OSIP was offering high premium.
If you don't find out for yourself why premium is
high, you are asking to find out the hard way. Do
you really want to put your money on the line not
knowing what the market clearly knows?
Once you look for
the news and don't find any, don't stop there. Do
a Google or other search for the stock's symbol
and do some reading. Here's another trick: go into
the Yahoo! message boards for the stock and ask
why call premium is high - I frequently get an answer
in minutes. On a stock as volatile as OSIP, looking
for news is vital. |
Now
consider the following chart to see my point about historical
volatility. Note that OSIP dropped $20 in November, the
month the great news came out about its own lung cancer
drug Tarceva. So it gets hammered on its own good news
and gaps up on a competitor's bad news. Sheesh.
Trends
are simply not reliable in such a volatile stock. Implied
volatility is one thing, but this stock moves all over
the board. Observe all the gaps up and down and the extreme
trading ranges. It is interesting how the gap down at
Point A and the gap up at Point B continued the trend
line already in place at Point A, but trust me, this is
not anything a technician could have predicted. Nor do
I really think the apparent continuation of the trendline
has any technical merit - I may be wrong, but I doubt
it. There have been periods when a bear call or bull put
spread would have worked marvelously on OSIP, as the chart
illustrates, but only after the most careful of research.
For me, such a volatile stock would always be a white-knuckle
trade. It's a great stock for the occasional straddle
trade, though (buy the call and put).
If
you are a betting man or woman, it makes more sense to
confine the bets to the casino - only because you can
have fun in the casino, even when you lose. But losing
money on trades is no fun at all.
Side
note: I don't see how OSIP can stay where it
is. It is a unprofitable, distressed stock, with an "F"
grade for financial health. CSFB declined to upgrade it
on the Iressa news, reasoning that the stock price "remains
rich" for its current earnings estimate of $2 per
share for calendar 2008. Yes, I meant 2008. This volatile
stock is up and down, up and down. It will not likely
stay where it is. The open interest is running 25:1 or
so in favor of calls, which means that option buyers are
extraordinarily bullish on OSIP, a sign for contrarians
like me to buy puts.
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are not brokers, investment advisers or securities
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sale or holding of any security. Your use
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