After selling off sharply on potential regulatory fears in early November, shares of SPDR S&P Biotech (ETF) (NYSEARCA:XBI) have put in a strong recent performance. Even so, biotech stocks still have underperformed the S&P 500 over the past few months.
However, I expect the biotech rally to continue and for XBI to close the performance gap in the coming months.
The selloff in early November was predicated on an expected Clinton victory, with fears of looming price controls in the biotech sector fueling the drop. The Trump victory removed much of that concern, especially given the reduced regulatory stance by incoming administration. This is a decided benefit for biotech stocks in the near-term.
From a technical perspective, XBI is looking like it is poised for a potential breakout to the upside. After holding major support at the $60 level, XBI has now taken out significant overhead resistance at $64.50. A move to test the recent highs at $68 may be in the offing.
Even given the recent rally, biotech stocks are still lagging the overall market. Normally highly correlated to the S&P 500, XBI is still trading a significant discount. Past instances when XBI was this cheap in comparison proved to be meaningful lows in biotech stocks.
XBI is comprised of both the small- and large-cap names in the biotech space. Interesting to note that of the top 10 holdings, only Amgen Inc. (NASDAQ:AMGN) has a market cap exceeding $100 billion. The top holding by weight, Ariad Pharmaceuticals, Inc. (NASDAQ:ARIA), was just acquired by Japanese pharma giant Takeda for $24 per share, pending regulatory approval.
This may likely be the beginning of further consolidation in the biotech space, leading to higher multiples and more upside for XBI going forward.
Implied volatility (IV) is still cheap in XBI, trading at only the 13% percentile. This favors long option strategies, so a long call spread play makes intuitive sense.
How to Trade XBI Here
Buy the XBI Feb $65 calls and sell the XBI Feb $68 calls for a $1.40 net debit.
These are the traditional monthly options that expire Feb. 17. Maximum risk on the trade is $140 per spread, and the maximum gain (achieved if XBI closes above $68 at expiration) is $160 per spread. Return on risk is 114%.
The short $68 strike is positioned at the next overhead resistance level of $68. I would exit the trade on a meaningful break of downside support at the $64.50 level while looking for the spread to realize maximum gain above the $68 level.
As of this writing, Tim Biggam did not hold a position in any of 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 email Tim at tbiggam@deltaderivatives.com.
