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How to Hedge Profits in Sarepta Therapeutics

BOTHELL, Wash. ( TheStreet) -- Shares of Sarepta Therapeutics (SRPT - Get Report) have soared on positive data for the company's Duchenne's muscular dystrophy (DMD) drug candidate eteplirsen. In one day, Sarepta shareholders realized approximately 300% overnight gains on their positions.

After a big move in small-cap biotech, it's often smart to hedge a position even if further upside is expected. The best hedge, of course, is to simply sell your position and move on. For bullish holders seeking further upside -- but also wanting to sleep at night -- there are ways to protect profits through options.

Sell Stock, Buy Calls: One approach is to simply sell your stock and roll into In-the-Money Calls. Ignoring tax implications on your stock position, this approach is often a good strategy as it provides a hedge (the cost of the Call is your maximum risk) while maintaining upside exposure.

To execute this approach you first need to define your time horizon, i.e. how long do you want to maintain this exposure? Let's say you wish to hold for one more month. In this scenario, for example, you would sell your shares at the current price of $32 and buy the NOV 30.0 strike Calls for $5.00. In this trade, assuming you swapped 1,000 shares for 10 Call options, your maximum risk is $5,000. So if the shares tanked back down to $10 (for example only!), rather than losing $22,000 from your un-hedged long shares, your loss would be $5,000.

This hedged option trade does have a cost: Sarepta shares need to increase to $35 to break even. You can reduce this cost further (but also cap upside) by selling NOV 40.0 strike Calls for $1.60 against the 30.0 strike Calls, thus reducing the total cost (and risk) to $3.40 per spread and capping upside above $40.

Keep Stock, Buy Puts: If you don't wish to sell your Sarepta shares, you can always buy Puts. Again, defining your time frame is important as constantly hedging up your position can get expensive, especially with this high IV name.

Assuming a one-month timeframe, you can buy the NOV 32.0 strike Puts for $4.80. As with the Calls, this is a defined risk position -- your stock is protected below $32 less the cost of the hedge (the Puts) and upside exposure is maintained after the cost of the Puts is covered. The stock needs to climb above around $36.50 to breakeven on the trade.

As with the Call position, a lower cost (albeit higher risk) alternative is to buy a Put spread. This can be accomplished by selling, for example, the NOV 25.0 strike Puts for $1.20 against the purchased NOV 32.0 strike Puts. This results in a lower cost of $3.60 and provides a similar hedge until $25. Below this level, your shares are fully exposed to downside risk.

Pelz has no position in Sarepta Therapeutics.

To learn more about using options to trade biotech stocks, check out Tony Pelz's book, The Biotech Trader Handbook or subscribe to Chimera Research Group.
Tony Pelz was a trader on a major European bank's proprietary trading desk, responsible for a portfolio with limits of more than $200 million. Prior to proprietary trading, Pelz worked with several global investment banks in roles ranging from corporate finance, M&A to credit and business development. He is author of The Biotech Trader Handbook, 2nd Edition, co-founder of the small-cap biotech research and trading site Chimera Research Group and operator of Pelz currently resides in Denver, Colorado where he trades for his own account.

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