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This Is How I Traded A Biotech Industry Blunder

Last week, Options360 established a bullish option position in SPDR Biotech ETF (XBI), based on both fundamental and technical reasons.

However, yesterday there was a ruling by the Federal Trade Commission that has cast a cloud over the sector causing me to re-think whether to maintain the position. I thought it might be helpful to share my process for not just initiating the trade, but also how I evaluate and manage the position through changes in time, price, and profit potential.

I have a feeling my final decision on whether to stick with the trade will be of the order of the old John Maynard Keynes quote, “When the facts change, I change my mind.”

First, let me share my reasoning for establishing the bullish position; here is part of the alert sent to Options360 members on May 9, when XBI was trading $84 per share.

“XBI is near equal weight (largest holding is just 1.3%) of small cap biotech companies. Most are not profitable but many have promising pipelines.

These firms (and biotech/healthcare) are fairly recession proof.

The larger pharma companies are always looking for acquisitions and usually willing to pay big premiums to fill their own often aging/coming off patent pipeline. And there has been a noticeable pick up in deals over the past few months.

Chartwise it has been in a decent uptrend and recently cleared resistance above $84. If this nascent bull flag can create a push above $86 and think a target of $90 looks possible.

I will use $83.25 as stop loss level.”

The chart below shows the $83-84 support level and the formation of a potential bull flag.

The recommended trade was to buy a July 86 call. On Monday, the stock rallied above $88 and we sold a short-term 91 call to leg into a diagonal at an advantageous price. Things looked good.

Let me backup, before I get to today’s dilemma.

One of the many attractions of Exchange-Traded Funds (ETFs) is their reduction of single stock risk; if one company has bad news or fails to execute its shortcomings, the decline won’t sink your entire position.

This makes using a sector ETF, especially for industries in which there can be a wide variety of outcomes, such as the biotech industry, a wise move in terms of risk management. Let’s face it, unless you’re an expert in the field, it is nearly impossible to keep up with all the research, progress, and potential applications for the drugs and treatments in development.

Using an ETF, which holds a basket of biotech stocks, some of which will fail and some that will achieve great success, is a time and financially efficient way to gain exposure for the sector.

So, much to my chagrin, XBI gapped down by some 3% on Tuesday in the wake of the FTC’s block of a proposed $28 billion acquisition of Horizon Therapeutics (HZNP) by Amgen (AMGN), causing shares of HZNP to plunge 23%.

This was a deal that was not supposed to have any trouble being approved. There was no overlap that would create less competition, and yet, it was blocked.

The drug/biotech industry is built on a model of small, often university and government-funded projects doing the initial research, hoping to develop a drug that can move towards Phase I testing.

If it passes muster then big pharma starts sniffing around to pick up the mantle, both financially and operationally, to get to Phase II and III, and ultimately, distribution.

This decision by the FTC (let’s face it, it’s an anti-business administration with an acute sense of the real need to reign in drug and healthcare costs) might have the unintended consequence of stifling innovation and development of medical breakthroughs if there is no path to continued financing, distribution, and profits.

If the regulatory environment changes in that acquisitions will be blocked the complexion of the whole industry changes.

Bringing us back to the trade. XBI dipped to $83.65, just above my stop loss trigger, before bouncing back above $85.

This morning I took another roll to collect premium and bring cost basis/risk down. This flexibility of options allows us to make adjustments to a more nuanced position. I’m staying with a more moderate bullish position and will be sticking with my stop to manage risk.

If you find yourself interested in learning more about me and my method of teaching even the most novice traders how to trade options, check out this presentation I put together to get filled in this link will take you directly to my Options360 presentation.

If you’re interested in joining Options360 and get in on all the action, you can follow this link to get signed up today!

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