Valeant Pharmaceuticals Intl Inc (VRX) is finally showing signs of bottoming after an epic 73% drop in VRX stock from its August highs. News that Valeant’s Philidor subsidiary was engaged in deceptive business practices — along with a scathing research report from Citron Research equating VRX to Enron — was the impetus behind the free fall.
Click to Enlarge On Nov. 5, Valeant CEO Michael Pearson was forced to liquidate $100 million in stock pledged against loans, with Goldman Sachs (GS) selling 1.3 million shares. This margin call selling drove VRX stock down to $73.32, with implied volatility in the options market jumping to an extreme reading of nearly 130%.
This also marked the low on VRX, with the stock recovering 16% to close at $85.41 yesterday.
I am definitely not an advocate of trying to pick a bottom in a stock that was getting crushed on continued bad news like VRX, instead preferring for the stock to show some support and head higher before jumping in.
The type of price action seen last week, though — with VRX making a new capitulation low on forced margin selling and then rallying sharply — is many times indicative of the elusive bottom in the stock.
Value investors are also looking at Valeant at these levels. Analyst Irina Koffler at Mizuhno thinks that VRX is worth $100 per share in a worst-case scenario. Other analysts have echoed similar sum-of-parts valuation arguments in defense of VRX stock at the current price.
The combination of bullish technical patterns along with more attractive valuations could finally put a floor in VRX stock. With implied volatility still north of 100% and the stock hard to borrow, puts are trading at a premium. This sets up a out-of-the money bull put spread trade to capture the rich IV while positioning to profit if shares of VRX don’t fall significantly further.
I would look to sell Dec $60 puts and buy Dec $55 puts for a 65-cent net credit. The maximum gain on the trade is the $65 net credit received per spread, with the maximum loss being $435 per spread. The return on risk is 14.94%, and with VRX closing at $85.41, the short put spread is 29.75% out-of-the money.
For risk management, I would close the position on a significant break below the $60 level on VRX stock to limit losses, while letting the spread expire worthless and keeping the initial premium if VRX stock remains well-behaved.
As of this writing, Tim Biggam had no position in the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can e-mail Tim at tbiggam@deltaderivatives.com.
