Volatility Is Coming to Big Pharma

There seems to be nothing politicians can agree on these days. Even still, there is one industry fearing that both sides are about to pounce on it: Big Pharma.

Pharmaceutical companies are never viewed as the “good guys.” But what’s happening now is a bit unprecedented. Despite remaining one of the largest industries to donate to political campaigns, both Republicans and Democrats are slowly turning their attention to drug companies.

This has happened before, of course. Who could forget the public shaming Martin Shkreli rightfully received for hiking the cost of a 60-year-old drug by 5,000% in 2015… or the EpiPen price hike outrage the following year?

These kinds of stories have stayed somewhat in the common discussion since then. But now, it looks like both parties in D.C. might at least do more than just shaming those responsible for price hikes.

President Trump gives his belated State of the Union address tonight. In it, he’s widely expected to broach the subject of how to bring down drug prices. It is truly one of the only areas he could reach across the political aisle and find support.

Just this morning, Senator Ron Wyden, member of the Senate Finance Committee, announced that “one way or another, executives from the seven largest Big Pharma companies will testify before his committee.

Wyden is the Democratic ranking member on the committee. But if you think this is a one-party issue, think again. He made his statement in response to Big Pharma’s refusal to Republican Chairman Chuck Grassley’s request for an open hearing. And he’s not particularly happy about that either, saying he’ll be “more insistent the next time.”

Others, including the plethora of Democrats running in 2020, have made this a core early campaign issue. Senators Bernie Sanders, Elizabeth Warren and Cory Booker have all unveiled specific bills in the upper chamber over the last six weeks.

Sure, nothing may come of it… as has been the case year after year. But as Wyden said, “one way or another,” this is coming to a head.

All of this foretells a building of volatility in the drug industry… one it hasn’t really had to deal with for a while. But if that wasn’t enough, one after another have lowered 2019 profit forecasts.

Pfizer and Allergan recently noted rising costs as a problem to keep a watch on. And that’s before any legislative action. If Congress does anything — even a token gesture to lower prices — these companies are not in a position to cope as they usually are.

Tonight is the State of the Union. Tomorrow, another major player in this industry is set to announce its own earnings, Eli Lilly. By the end of the month, we could see up to seven drug executives in the Congressional hotseat. And a bipartisan drug bill – no matter how impactful it really would be – is in grasp. There’s going to be plenty of reasons to see price swings in the next few weeks.

So, to take advantage of this, we look to one company that has epitomized the drug industry for decades, Pfizer. And we’re going to use a strategy that profits no matter what the outcomes of all of these catalysts are. Let’s get into it.

A Strategy For Short Term Volatility

A long straddle is an option trade that lets investors profit no matter which direction the underlying stock moves. The only thing that matters for this type of trade is that that underlying play does indeed move.

That’s why it’s perfect for the current scenario in the drug industry.

The way it works is by buying two options that at first seem counterproductive. A trader looking to enter a long straddle would buy a call option with a strike price near the current trading price of the underlying stock. He also buys a put option with the exact same strike price and the exact same expiration date.

Obviously, that sounds silly. Why bet a stock will go up AND down at the same time? But if you think about it, it makes great sense. On option is only a contract that gives the owner the ability to buy or sell a stock at a certain price by a certain date. A call lets them buy shares for that strike price. A put option lets them sell shares for that price. Think what happens when shares move drastically in either direction.

If shares rise sharply, the call option will give the trader the chance to buy shares at a significant discount to the current price. If shares fall, the trader could simply buy shares at the now-lower price and sell at the strike price of the put contract.

Here’s how that looks:

long straddle

Source: The Options Industry Council

Let’s look at a specific trade on Pfizer (PFE) options…

A Specific Trade on PFE Volatility

If a trader were to buy a February 15 $42.50 call for $0.37 per share and a February 15 $42.50 put for $0.60, he would enter a long straddle for $0.97 per share. Since each of those contracts represent 100 shares, that’s a net debit of $97.

That means shares would only have to trade below $41.53 or above $43.47 by the end of next week for this to turn a profit. That’s means shares of Pfizer would have to move just 2.3% throughout this whole period of unprecedented volatility for the trader to reap a profit.

Of course, there’s not a lot of time before these options expire. That’s the risk. But a single line in the President’s speech tonight could easily swing a stock like Pfizer much more than 2.3% in the first five minutes of trading tomorrow. And with Eli Lilly reporting tomorrow, that’s just another potential catalyst for Pfizer to deal with.

This could be a quick 10-day profit with an entry cost of less than $100 on one of the world’s largest companies. These kinds of opportunities don’t come around often

— The Option Specialist

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About the Author: The Option Specialist