MorningWord 6/24/14: VRTX and The Binary Biotechs

by Dan June 24, 2014 9:24 am • Commentary

I don’t spend a lot of time on mid to small cap biotech stocks for one simple reason – because I don’t know the what, when or why.  Throughout my career, I have seen a very small group trade/invest the space well, and those that do usually have some sort of edge.  For the most part the best sell-side analysts and buy-side portfolio managers who cover the space are former doctors, or worked in the medical research field and have a deep understanding of the uses of potential drugs and a network to tap to get a sense for the likelihood of effectiveness of new cures with the worlds worth diseases.  For the most part, these stocks trade on the potential for drugs that they are developing to be approved by the FDA, have potential blockbuster status, and be bought by a large pharma company starved for growth.

So I have no idea to the what.  The dates for trials and approvals are moving targets, with frequent surprise announcements leaving me with no clue as to the when.  And the knowledge gained in 10th/11th grade biology/chemistry hardly helps in the why.  If most investors feel they have little edge in investing alongside professionals, doing so in Biotech will only drive the point home.

Don’t get me wrong – there are plenty of peeps out there who have made a fortune by doing their work and finding small companies early who blossom into behemoths, but with little sense for the what, when and why, I assume it hard to maintain conviction with such dramatic fluctuations in price.

This morning, there is one such instance.  Vertex Pharmaceuticals (VRTX) presented data that showed the combination of two of their drugs “significantly improved lung function in clinical trials on patients with the most common form of cystic fibrosis“.  The stock is up 50% in the pre-market, from $66 to $100 on the news, or $7.5 billion in market cap.

On June 16th, a friend of mine David Seaburg, who heads Sales Trading at Cowen and Co, suggested I take a look at the stock on a day that it was down on a competitor’s research report.  David reiterated his analyst’s published view that:

The imminent release of results from VX-809’s (Cystic fibrosis drug)  Ph. III trials has the potential to be one of the biggest binary events in biotech during 2014. We think that there is a 60% chance the trials succeed, and a 40% chance they fail (or have mixed results). We expect VRTX’s stock to go to $100+ on success, but $40 on failure.

We took at a look at the stock.  Not that we would have a clue on the fundamentals, but when we have smart people who do lay out probabilities of potential outcomes, we look at options to see if there is anything mis-priced.  First, we looked at Implied Volatility in the stock and made a fairly simple conclusion that options players had adequately priced the potential for a 50% increase or decline over the next month or so.  The one year chart below of 30 day at the money IV (blue) vs the 30 day Realized Vol (white) demonstrates the insanity of short dated options prices (been realizing 42 vol and options prices at about 145 vol):

VRTX 30 day at the money IV (blue) vs 30 day realized vol (white) from Bloomberg
VRTX 30 day at the money IV (blue) vs 30 day realized vol (white) from Bloomberg

We routinely make the point that trading events with long premium options strategies offers many pitfalls with one primary advantage. To do so effectively, you need to get a lot of things right – direction, timing and magnitude of the move – but in exchange for defined risk.

Taking a look at the July expiration Options Chain we can make a few interesting observations about just how hard it would have been to make a profitable trade if you merely took the stated odds of success and worked from there:

VRTX July options chain from Bloomberg
VRTX July options chain from Bloomberg

First off, the Jul19th 67.5 straddle was offered around $22, implying a break-even area below $45.50 or above $89.50.  The difficulty with such a straddle is if you buy it you are risking $22 to possibly make $5-$15 depending on how much VRTX moves on the event.  Not great risk/reward to simply buy the move.

You could try to reduce your premium at risk by buying a strangle, since the market is expecting such a big move.  But even the Jul19th 50/85 strangle (buying 50 put and 85 call) would have cost about $6.30.  That would yield break-evens of below $43.70 or above $91.30.  Similar to the straddle, but with less premium at risk.  At that point, it’s a question of how confident you are that the event results in a very big move.

Basically, when options prices are so expensive, long premium bets become quite difficult, and it comes down to your conviction.  If you outlined a direction, and you end up correct, you can do well (though even the Jul19th 75/85 call spread cost about 3.75). But you’re risking your entire premium given the binary nature of the event, so you better be prepared to lose it all in one day as well.

The weeklies that expired this week look like they were the ones to own for the move, but we easily could have gone through the week without the announcement meaning all those out of the money options would have expired worthless. Do that a couple weeks in a row and you’ve probably lost more than you’re going to make once you’re right.

In short, that’s why we rarely get involved in huge binary situations like these.  Without the fundamental conviction and knowledge of the individual biotechs, it’s very difficult to find a worthwhile structure no matter the outcome.