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TheStreet Open House

How to Trade Sarepta After the FDA Setback

Stocks in this article: SRPT

NEW YORK (TheStreet) -- Many investors and traders avoid biotech and drug stocks altogether because they can be highly volatile and gut wrenching. Sarepta Therapeutics (SRPT - Get Report) became the latest poster child of drug-sector volatility Tuesday when some bad news from the FDA sent shares plummeting more than 60%. The stock fell again Wednesday. All told, more than $800 million was erased from Sarepta's market value in two days. 

As an active trader, I see stocks gap lower (and higher) every day, albeit usually not as severe as Sarepta. When a stock declines more than 60% in a single day, my first instinct is to assume bankruptcy protection is next. But biotech and drug stocks can recover from such extreme volatility, and that's particularly true for Sarepta because the door is still open for FDA approval of its Duchenne muscular dystrophy drug eteplirsen. There's even a wild card which make get Sarepta's drug approved sooner than the market expects.

The Street's
Adam Feuerstein wrote an outstanding article laying out the Sarepta landscape. Feuerstein describes what went wrong, and more importantly, the anticipated amount of time before eteplirsen may reach another decision point with the FDA again. The long and short of it is Sarepta investors may have to wait another two or three years for an FDA approval decision on eteplirsen

With that said, there are a couple of favorable ways for traders to play Sarepta. Since large gaps lower generally have one or two days of follow-through, buy shares near or at the close on Thursday or early Friday (if near the lows.) After three down days, we typically see what's known as a "dead-cat bounce." Close out the trade with (hopefully) your gains.

A variation of the dead-cat bounce strategy is to write covered calls. This is what I'm doing with Sarepta. Because option premium is off-the-chart rich, I bought shares at $12.71 and lowered my effective cost basis down to $12.06 by selling the $13 strike call option for 65 cents that expires Friday.

Knowing that Friday should mitigate potential declines during Wednesday and Thursday, I'm able to benefit from the intense volatility priced in while at the same time lowering my own volatility/risk.

The other approach is for investors with a much greater time horizon in mind. If you're a believer in the company and eteplirsen and think the market has over-reacted creating a value buy, you will want to sit on your hands a little longer.

Sarepta is the equivalent of a zombie right now and will continue to be for several months. Historically, after a significant negative shift of investor perception, shares tend to drift aimlessly lower for at least a quarter or two absent a strong bullish catalyst.

A feel-good press release or two won't cut it. According to Feuerstein we also know that investors won't expect the desired bullish catalyst for a year or more. This makes utilizing an option strategy especially appealing for those with a long-term horizon.

While we don't have a crystal ball and can't predict the future, we know historically that we can expect weakness in shares looking out three months. Since the company is essentially a one-trick pony, I think it makes the odds more likely Sarepta will follow the typical price behavior pattern.

The February expiration date is in about 100 days, or a little more than one quarter. We can buy shares for $12.60 and hedge through selling February call options with a strike price of $16 for $1.60 at the time of writing.

A covered call lowers the effective cost basis more than 10% to $11 per share. It also pays you for your waiting time and using the February expiration lowers the chances of missing out on a substantial move higher compared to writing a covered call six or more months from now.

So even if you're planning on buying and holding for much longer, I don't think you want to go much beyond February because the situation is so volatile. It's impossible to peer that far in advance with a reasonable degree of positive expectancy.

There's a wild card to eteplirsen and it's a challenge to quantify, so I will simply mention it as a long shot. Parents of kids with Duchenne muscular dystrophy believe eteplirsen is a life-saving therapy and are livid about the FDA's decision to delay Sarepta's ability to seek approval for eteliplirsen. I can't think of a more motivated person than a parent seeking a life-saving medication for their child, so don't discount their ability to force FDA to reverse its decision. To be clear, I don't expect or even think the odds favor a material change in position by the FDA, but I wouldn't bet against it (or the parents) by short selling shares.

At the time of publication, Weinstein was long Sarepta.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Robert Weinstein is an active trader focusing on the psychological importance of risk mitigation, emotion and financial behavior of market participants. Robert co-founded the investing blog StockSaints, where he writes a journal about his trading activity and experiences.

In addition to TheStreet, Robert also contributes to Real Money Pro, providing real-time trading ideas for stocks, options and futures.

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