The recent acquisition headline from Gilead Sciences, Inc. (NASDAQ:GILD) rekindled Wall Street’s love for the biotech sector. As a result, the SPDR S&P Biotech (ETF) (NYSEARCA:XBI) rallied 13% in two weeks. Traders are chasing prices higher expecting even more buyout headlines.
So is it too late to profit from the run? No. This is an uber-bullish equity market and it remains resilient. So investors will buy the dips, and that’s why they have been shallow in nature. And therein lies my opportunity.
The biotech trade is always a momentum bet. Currently Wall Street is betting it’ll go up. I want to use the XBI ETF to join the herd.
No, I don’t need to chase XBI prices higher. After all, I am not one to buy and hope for further rallies. I instead like to bet on proven support levels to generate income. I sell downside risk against those levels then let time do the work for me.
Click to Enlarge The biotech ETF being a momentum ticker, it moves fast in either direction as evident from the chart. This makes it difficult for most traders to time well. On the way up, it seems like it’s due for a correction at any time. On the way down, it appears to be falling into an abyss. Either situation would scare most traders out of trading it.
Using XBI options eliminates the need to be perfect with timing.
Individually, biotech companies are not ideal for selling puts since the nature of their business leaves them susceptible to headlines. And if they get hit with a negative one, put sellers will suffer greatly. Choosing clever levels to sell would minimize the damage. Nevertheless it’s dangerous.
Alternatively, the XBI is an ETF that is a collection of companies but they are each small pieces of the whole. These are companies like KITE Pharma Inc. (NASDAQ:KITE) (3.6%) and Gilead Sciences Inc. (NASDAQ:GILD) (2.3%).
Selling puts in the ETF rather than the single companies mitigates the headline risk. Since the ETF is made up of little pieces of each then if a company-specific headline hits, it’s diffused.
XBI ETF Trade Idea
The Bet: Sell XBI Dec $68 put and collect 90 cents per contract to open. This is a bullish trade where I have 90% theoretical odds of success. But if the price falls below my strike then I own the shares and would accrue losses below $67.10.
For those who want to mitigate the risk of selling naked puts, they can sell spreads instead. The theory is the same but with much less money at risk.
The Alternate: Sell XBI Dec $68/$66 credit put spread, where I have about the same chances to yield 10% on risk. Compare this with buying XBI shares outright and then hope it rallies 10% just to match the performance of the spread.
In either of my setups, the XBI price can fall over 15% and I can still bank maximum gains.
Since there are no guarantees when investing in the stock markets, I never bet more than I am willing 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.