Trading Bull Calls in Biotech

by Tyler Craig | June 27, 2012 10:49 am

Pop Quiz: Over the past month, which sector has outperformed the market by the largest margin?

Answer: Health care.

Sector performance can reveal a great deal about the underlying strength or weakness of the broader market. Were we to poll traders in the bull camp on which sector they’d prefer to lead the market, rest assured that it wouldn’t be health care. Along with utilities and consumer staples, many consider health care a defensive sector whose leadership usually occurs during times of broader market weakness. A healthy bull market is typically led by more offensive sectors, such as technology or industrials.

One industry within the health-care space that has been a gathering ground of sorts for the bulls is biotech. While the S&P 500 Index is down roughly 7% since April, the iShares Nasdaq Biotechnology ETF (NYSE:IBB[1]) has climbed 3%, showing stark outperformance.IBB chart 300x181 Trading Bull Calls in Biotech
Click to Enlarge

The past week found IBB taking a breather by basing near its 52-week highs. Such a consolidation may provide the necessary fuel for biotech’s next up-leg.

Unfortunately for option traders, IBB’s volume averages only about 500,000 shares a day, which translates into somewhat sparsely traded options. This illiquidity is keeping the bid-ask spread wider than desired for most option contracts.

Traders willing to brave these illiquid seas using limit orders might consider using an August 128-132 bull call spread. The trade consists of buying the August 128 call while selling the August 132 call. Currently the spread is priced around $2.10, making the max risk $210 and the max reward $190. Consider it a bet that IBB rises to $132 by the August expiration.

One potential wild card is the pending announcement regarding the fate of Obamacare. Given the health-care sector’s sensitivity to the passage or striking down of such legislation, it stands to reason that biotech may be affected as well. Whether the effect is positive or negative, obviously, remains to be seen.

Endnotes:
  1. IBB: http://studio-5.financialcontent.com/investplace/quote?Symbol=IBB

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