Anatomy of a Trade: $IBB Nov Put Fly

by CC November 12, 2015 11:24 am • Commentary

A little over a week ago we took a look at Bio/Pharmatech stocks and offered a way to fade the recent bounce in the sector in the very near term. It’s our belief that the scrutiny on drug pricing is in the early innings, and will likely continue to be front page news as more dodgy practices are exposed. Not everyone in the space will get the media/political treatment that has negatively impacted a handful of stocks to date, but we suspect investors will shoot first and ask questions later and this behavior quite possibly mark’s the end of a fairly epic multi-year run.

We chose the etf IBB this time, here was the trade idea:  

Buy the IBB ($337.50) November 340/320/300 put fly for 4.40
  • Buy 1 November 340 put for 10.50
  • sell 2 November 320 puts at 3.70 (7.40 total)
  • buy 1 November 300 put for 1.30

Rationale – This trade has a breakeven (335.60)  on the downside very close to where the stock is trading (337.50) and defines risk if the index continues higher to just 4.40. Its max profit potential is 15.60 at $320 but it isolates a wide band of where it can be profitable between 335.60 and 304.40. This is essentially a consolidation trade after the index’s bounce off the lows.

The index was unable to test its 200 day moving average on the upside and now sits on its 50 day, so far holding:

[caption id="attachment_58520" align="aligncenter" width="688"]Screen Shot 2015-11-12 at 9.03.49 AM 6 month IBB from LiveVol Pro[/caption]

With the etf at 327 this fly is worth about 7.75. It’s worth 13 intrinsically, meaning there’s about 5.25 in risk premium still unrealized. The max profit value of the trade of the etf is at 320 on expiration, where it would be worth 20. Therefore, the best way to look at this trade as far as management is that there’s a little buffer to the upside where you can be patient. If the etf holds here you can be patient as long as it doesn’t start to move substantially higher. It’s breakeven on the upside is 335.60, so 330 is probably good mental stop if it moves higher. At that point it can still be taken off for a profit.

To the downside there’s lots of room to make even more on the trade. A break of the 50 day moving average quickly puts 320 in play. If that were to happen it may be a good idea to take some or all of the trade off as it would be more than a double at that point. Obviously, since it’s short premium the more time you can be patient with a trade like this (with the etf near 320) the more profitable it will be. This is an example of a trade with great risk reward, but one where patience once it begins to work can really pay off. Mental stops if the etf were to start to move aggressively in either direction is the way to go now.