Yesterday, Celgene Corporation (NASDAQ:CELG) caught a downgrade and the stock fell 4% on the headline. Money fled to Biogen Inc (NASDAQ:BIIB) which caught the opposing upgrade.
Biotech and pharma stocks make for scary falling knives. Catching them can be hazardous to your portfolio. So buying CELG stock here expecting an immediate bounce is reckless. Instead, I structure my trades to leave room for error just in case my timing is not perfect.
To do this, I use CELG options instead of trading its underlying equity. There I can choose levels based on actual support zones. The trick is to believe in my chart analysis and be willing to own the shares lower if price goes against me.
Click to Enlarge Fundamentally, Celgene is not cheap. Its price-to-earnings ratio is at least double most of its competitors except perhaps for Eli Lilly and Co (NYSE:LLY). Its price-to-book is a whopping 13 times so it’s hard to argue for value when choosing my support levels. This leaves me needing to use the charts in order to find support as a base for my trades.
For the past year, the biotech sector is up 18%. CELG on the other hand is up 34% even after this dip. So it is entirely possible that I’m early in catching this falling knife. This makes it even more important for me to build a sizable buffer between current price and my level of risk.
CELG stock has traded inside an ascending channel for over ten months and this dip nearly brings it to the mean. At this level of $137.50 per share the stock is revisiting a pivot point. This was resistance from which the bulls broke through at the end of August. Now it needs to prove itself as forward support. Otherwise it is conceivable to retest the $132 per share.
Even then, it would simply be at the bottom end of the channel thereby leaving the directional move of Celgene intact. Nevertheless, it is better to be overly cautious than too optimistic.
Expectations are important. Currently CELG is trading just below the average price target on Wall Street. Analysts are in a holding pattern where most of them have a buy rating on the stock. So there isn’t much to learn from their opinions with regard to expectations.
Suffice it to say that there is technical risk here, but using options, I can account for that possibility.
CELG Stock Trade Idea
The Trade: Sell CELG Jan $115 puts and collect $1.20 per contract. This is a bullish trade which has an 85% theoretical chance of winning. But if the price falls below my strike, then I accrue losses below $113.80.
Selling naked puts in this sector is scary. Those who want to mitigate the risk can sell a spread instead. There the maximum loss is much smaller.
The Alternate Trade: Sell CELG Jan $120/$115 bull put spread which would yield 10% on risk if it wins.
Neither setup requires a rally to profit. I can still reap maximum gains even if CELG stock falls another 17% from here.
Investing in stocks is risky, and regardless of how careful I am, 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.
