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One Way to Play the Dip in Big Pharma...

IT COULDN'T HAVE HAPPENED TO A NICER GUY

Big pharma stocks have been taking it in the shins over the past few days as many of the industry's biggest names are breaking down in the wake of changing healthcare legislation and increasing scrutiny of highly addictive opioids.  The general public will have little sympathy for bludgeoning, however.  The industry is so unpopular that a 2016 Gallup Poll showed its image had the worst net-positive rating in the 16 year history of the study.

A quick glance shows that Merck (MRK), Celgene (CELG), Gilead (GILD), BioMarin (BMRN) are some of the names showing symptoms of fatigue, difficulty breathing, vertigo, unprovoked bleeding, temporary blindness, depression and suicidal thoughts (it's almost as if they're using their own products)...


As one would expect, the dramatic moves (some as big as 10 ATRs in 5 days) have been accompanied by corollary spikes in implied volatility.  The November ATM puts for Merck are currently being priced at an implied volatility of 23.5% versus an empirical volatility of just 14% for the same time frame (note: this is on the heels of a small miss on 3rd quarter earnings on 10/27).


BUYING THE DIP

As the overall market continues its 8 year rally having gotten a boost of adrenaline from a business-friendly - and wildly unexpected - election outcome, buying opportunities have been scarce.  Here's one way to profit from big pharma's recent decline:

The pharmaceutical ETF, IBB, has obviously reflected the losses in the sector and this could be a buying opportunity; but risk abounds should the losses continue to mount.  One way to offset the risk is to use an option strategy called a ratio-backspread.  This play involves selling near or at-the-money options to finance the purchase of a greater quantity of cheaper, away-from-the-money options.

As of the time of this writing (midday 10/30/17), the IBB is trading at roughly $317.  The November $317.5 puts currently have a bid price of $5.90 and the November $305 puts have an offer of $2.00.  Buy selling one $317.50 put and buying three $305 puts for every 100 shares of the ETF purchased, the trade will have a max loss of -7.4% over the life of the options and the max loss will only be realized at $305 on the expiration.

Here's what the trade's PnL looks like at expiration:

If volatility continues to spike, the put protection creates a downside breakeven at roughly $280 and the IBB only needs to clear $317 on the upside to be profitable.

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