Biotech Investors Can Take Some Options Medicine

There's a massacre in the streets, and its name is biotech.

As of March 21, the biotech index was 27% off its year-to-date high. Stocks such as Immunex (IMNX Quote) and Biogen (BGEN Quote) have both taken it on the chin, giving up nearly all the gains acquired over the year.

The recent Fed rate hike did show some relief to beaten-down sectors like biotech, but once the Greenspan hoopla is over, the sector's future is unclear. How can traders take advantage of these massive pullbacks without hanging themselves out for further unknown directional risk?

Some may argue that the biotech sector was due for a pullback. With price-to-earnings ratios hovering above 2500 and no end in sight, it's only fitting that the top of the market was called two weeks ago by heavy call -buying by speculators. Massive call-buying generally leads to a top in the markets, as public buyers tend to be right on the trend, but wrong on both ends.

In the past, biotech stocks have fallen while stocks in the Dow Jones Industrial Average moved higher, in a sort of mirrored relationship. But with technology leading the way for many new developments in biogenetics, biotechs may have just paused before heading to new highs this year. Immunex is up 87% since the beginning of the year, but is about 23% off its peak from early March.

Investors who currently own biotech stocks may well be on respirators right now. While it may not take shock paddles to jumpstart the biotech sector to the upside, investors can take steps to avoid going into cardiac arrest should the sector continue to slump. You can protect yourself in a correction without exiting the stock position. Here are a few ways.

Using long puts as a hedge against long stock positions. It's a simple strategy that can be used to protect your long stock position from a drop in the market. Example: 100 shares of Immunex have climbed to 80 from 50 per share during the year. The trader can buy puts as protection: An Immunex December 80 put at a price of 20 equals $2,000.

Therefore, $2,000 of put insurance protects the position until December. If the stock continues to rise, the position could still be profitable. The only problem, then, is the cost of the long put. Immunex options are very high in volatility, which only adds to the cost of insuring the stock. So what can be done to protect your investment without putting more money on the table?

Using covered calls as an approach to limiting risk. Using a short call, the trader can offset the position by taking in premium against the owned stock. Using the same example of Immunex above, the trader decides to sell the December 80 call for 20.

In this case, the trader collects 20 points of premium as a hedge against his long stock position. The premium an investor collects will help protect against losses to a limited degree if the stock should drop. The best-case scenario is that the stock price either remains the same or rises to expiration so the call you've gotten paid for expires worthless and you keep the stock.

The big problem here is that covered calls only protect against a limited amount of downside action. If the stock takes a big dive, the trade could still lose a substantial amount of money, but if you own the stock, you already have an unlimited risk position anyway. Another problem is that trading covered calls limits the trade's profit potential to the amount of the call premium received added to the stock price. Your upside is limited in a sector that typically moves dramatically on the way up.

What if you want to take a long position in Immunex, but want to limit your risk exposure? Because of the differences in option prices, there are some great options trades that give you a position with a better risk-to-reward ratio, as well as a high probability of being right. Options volatility in Immunex has risen 40% in just the past two weeks alone. Obviously, the way to trade these options right now is to sell them, due to their high volatility.

To limit risk against short options, you can buy out-of-the-money options as protection. The prices are a little steep -- the January 2002 40 put is trading between 11 and 11 3/4 and the 50 put is going for 17 to 17 7/8 -- but there's probably no better way to get long-term protection short of not owning any biotech.

Use an options spread position. Not all stocks have put options that reflect the prices that Immunex does right now. This is because of the stock's volatility and the implied option volatility of each option strike. The near-money options are showing a greater volatility or demand than the further out-of-the-money options. This is called a volatility skew. Volatility traders use this type of price disparity to create hedge trades, in anticipation that volatility levels will return to normal in the future. There are several ways to take advantage of volatility skews, but one of my favorites is using what is referred to as a bull put spread.

Now, Immunex was recently at 58 1/2. Notice that if we were to buy the January 2002 40 puts for 11 3/4 and sell the January 2002 50 puts for 17 1/2, this trade would give us a net credit of 5 3/4. This type of spread trade is a bull put spread, which has limited risk and limited reward. This is a great spread considering that the stock is 8 1/2 points above the selling strike, and nearly 14 points away from break-even on the position at expiration.

The objective of this trade is for the put premium to decay, causing the spread that the trader sold to narrow, and allowing the trader to buy the spread back for less than it originally brought in. This stock could move sideways until expiration, and the trade would still be profitable.

Perhaps the biggest lesson to be learned here is the use of limited-risk options strategies. Risk management is absolutely essential if you plan to trade high-volatility markets. Before you have your next heart attack, a dose of options may keep you out of the emergency room.