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January 7, 2005
A Lesson
in Real Volatility
by John Brasher, CallWriter Publisher
| No matter how much you
know about the market, even about particular industries, stocks
can surprise you. And most of the surprises tend to be bad
ones. Truth is, though, the stocks that teach the hardest
lessons usually (like the rattler) were giving plenty of warning
to the trader who was listening. The lesson of this article
is that volatile stocks have to be approached v-e-r-y carefully.
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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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