Trade Idea – $XLV: Back to the Pharma

by Dan November 6, 2015 3:40 pm • Commentary

On Wednesday we laid out a bearish trade idea in the IBB, the iShares Nasdaq Biotech etf (read here) largely as a result of a poor technical set up, poor relative performance to other market sectors and generally cheap options prices given what we perceive to be news flow that is only likely to get worse in the coming months.

Today the headlines in the sector are focused on big pharma, and to be fair its hard to tell the difference anymore between the likes of Bristol Meyers / Eli Lilly / Merck and that of Amgen / Celgene / Gilead, they are all Big PharmaTech to me.  Back to the headline, from the


It’s our sense that this sort of negative sentiment towards the space, that some dismissed as a sort of election year political sport is much more than that. As we’ve said all along, old people vote, and this seems to be picking up bi partisan steam. And will take at least months, if not quarters to sort itself out.

Given how quickly the situation at Valeant (VRX) has deteriorated, investors may look to continue to rotate out of Big PharmaTech.  For the purposes of today’s trade I want to look at the XLV, the Heathcare Select etf, who’s top ten holdings make up 50% of its weight:

From Bloomberg
From Bloomberg

You may notice the top holding is Johnson & Johnson (JNJ), which is 10.5% of the weight, who gets 40% of its sales from selling drugs, 35% from medical equipment and the rest from consumer products.  This is important to the trade, as more than 55% of its sales come from outside the U.S. and the recent surge in the dollar should be a massive headwind for companies like JNJ.

Given the potential for increasingly negative sentiment towards industry practices, and the large exposure to the strength of the U.S. dollar, despite very reasonable valuation and decent yields, the XLV looks ripe for a short back to recent support at $65 after just being rejected at technical resistance at $73:

XLV 2yr chart from Bloomberg
XLV 2yr chart from Bloomberg

Short dated options prices have come in hard of late, along with realized vol (white line below), but realized remains below implied (blue line below), suggesting that traders expect the etf to settle down a bit.  If that is not the case, and realized picks up as I expect it to into year end as investors will look to reduce exposure to the space, then options could end up being cheap for those looking to pick a direction:

XLV 1yr chart of 30 day at the money Implied Volatility vs 30 day Realized Volatility from Bloomberg
XLV 1yr chart of 30 day at the money Implied Volatility vs 30 day Realized Volatility from Bloomberg

Here is the trade we are very near putting on:  

Trade: XLV ($71.40) Buy the March 70/60 put spread for 2.00

Break-Even on Expiration:

Profits: gains of up to 8 below 68 with max gain of 8 at or below 60

Losses:losses of up to 2 above 68 and total loss of $2 above 70

Rationale: There’s a chance the bad news in PharmaTech keeps on rolling. Something seemed rotten at the core of at least part of this industry and everyone involved is likely to see new found pricing pressure as a result of the added scrutiny.