Wall Street has been confused about the prospects of the pharmaceutical industry for almost two years. The 2016 U.S. presidential campaign and election results wreaked havoc with their stocks. First, investors feared what candidate Clinton promised she would do to them if elected president. So iShares NASDAQ Biotechnology Index (ETF) (NASDAQ:IBB) fell 20% on the threat.
But then they spiked to recover right back as Trump prevailed. Now investors fear the repeal of Obamacare so the stocks rally when the president’s efforts to push the bill to repeal fails.
Allergan plc Ordinary Shares (NYSE:AGN) stock, in general, follows a trend on the industry from the stock price perspective. However, even though the IBB is up 25% year-to-date, AGN recently corrected down 13% and is now approaching the support level from last November.
Click to Enlarge So obviously it has some Allergen-specific issues with which it was dealing. Over the past 52 weeks, instead of being up 10% like the industry exchange-traded fund, AGN stock is down 16%. I want to profit from the price action from here through year-end.
Although it carries a three-digit stock price, fundamentally speaking AGN is not bloated. Most analysts have it rated as a “buy” with a few “holds” and their average price target for it is $275. So it is clearly trading well below where the experts expected to be. This is the definition of potential and I want to capitalize on it.
I think that the selloff in AGN has gone too far too fast, so I do want to trade it from the bullish side today. But I won’t be buying the shares outright because I don’t like to chase upside hopium. Instead, I want to bet that the downside limit is near. Meaning that the selloff is nearing an end in Allergan stock.
In essence, I would like to get paid to open a trade today betting on the fact that proven support levels will hold through the year. But since we never really know how deep selloffs can be, I will create a sizeable buffer zone just in case I am early in my estimate.
The Bet: Sell AGN Jan 2018 $160 put and collect $1.50 per contract to open. This is a bullish trade that has a 90% theoretical chance that I retain maximum gains. But if the price falls below my strike then I am will lose money below $158.50.
I can mitigate the risk involved in selling naked puts by selling spreads instead.
The Alternate Bet: Sell AGN Jan $165/$160 credit put spread where I have about the same odds of winning. If so, then the spread will deliver 10% in yield. Compare this with buying AGN stock here and with no room for error expect a rally to profit. With either of my setups, I can profit even if prices fall an additional 20%.
Investing in the stock market is risky so I never bet more than I can afford to lose.
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him as @racernic on twitter and stocktwits.