Trading Biotech With Options: Exelixis

NEW YORK ( TheStreet) -- This new weekly column is intended to deliver actionable trade ideas using options for (mostly) small-cap biotech FDA drug approval and clinical trial catalysts. Where relevant, I will also focus on non-catalyst trade set-ups and other options-related topics in the biotech sector.

For those new to biotech investing, FDA drug approval and clinical trial catalysts cover a wide spectrum of major stock-moving events: Phase III clinical trial results, FDA drug approval announcements and FDA advisory committee meetings.

Small-cap biotech stocks are a high-risk asset class, which is why I like to use options when investing. Bad news -- whether it's poor data from an important clinical trial or FDA deciding to reject a new drug application -- can cause a biotech stock to plummet within minutes. Likewise, good news -- a successful clinical trial or an FDA drug approval -- can double the value of a biotech stock.

You get the point -- biotech investing is a high-risk, high-reward endeavor with binary outcomes. Trading or investing in just the equities exposes investors to a huge amount of risk and limits strategic choices. That is, investors can only buy, sell (if you already own) or short.

Investing with options, on the other hand, increases the strategic choices available to an investor and can reduce risk while maintaining significant upside. I really believe that options are a perfect investment tool for the volatile biotech sector.

I intend to use this column to show investors how to use options in biotech investing and each week, I'll discuss specific options trades. First, a quick sketch about my background and experience: I have more than 15 years as an options trader and currently trade options for my own account, exclusively focused on biotech catalysts. I'm the author of The Biotech Trader Handbook, co-founder of the biotech research and trading site Chimera Research Group and run an options trading web site, PelzOptions.com.

Here's my first biotech options trading idea:

Exelixis ( EXEL) is expecting to hear from FDA about a drug approval decision for its thyroid cancer drug cabozantinib by November 29. In early August, Exelixis announced a large equity and convertible bond offering that sent shares tumbling from over $6 to around $4.25. Last week, FDA notified Exelixis about the cancellation of a previously scheduled advisory panel for cabozantinib. That news caused Exelixis' shares to spike over $5 in after-hours trading but the stock quickly sold off to the low $4 the next day.

I expect Exelixis shares to continue trading between $4 and $6 (but mostly around or below $5) before November expiration (Nov. 17) due to the back-and-forth selling and buying pressure between underwater shareholders, convertible bondholders and new speculators.

Investors can take advantage of this Exelixis situation by executing the following options trade:

Sell (10) NOV 4.0 strike Puts at 0.35 = $(350)
Buy 10 NOV 4.0 strike Calls at 0.75 = $750
Sell (20) NOV 5.0 strike Calls at 0.30 = $(600)
Buy 10 NOV 6.0 strike Calls at 0.15 = $150

Trade Initial P&L = $(50) Credit

This is a Credit Call Butterfly -- that is, I am actually being paid to put on this position (not much, $50 for this size, but still being paid nevertheless.) The position involves buying a Call Butterfly (see above) and selling a Put to fully finance the cost. The key risk is obviously to the downside since we sold the Put. Unless negative data comes out prior to November option expiration -- or the company unexpectedly announces a delay or other negative news -- I would expect Exelixis' share price to remain above $4 given the impending Nov. 29 FDA drug approval decision date.

Obviously, I could be wrong. Maximum profit for this trade size is $1,050 if the shares trade to $5 by expiration and this profit tapers off between $4 and $6. (See the P&L diagram.)

If the stock trades below $4 by Nov. 17 expiration I will be assigned the shares (1,000 shares for this size trade) and be positioned to either hold into the possible run-up, sell 4.0 strike DEC Calls against the shares (i.e. trade into a covered Call) or simply remove any risk and sell them.

Pelz is currently long Exelixis shares.

Follow Tony Pelz on Twitter.

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 PelzOptions.com. Pelz currently resides in Denver, Colorado where he trades for his own account.

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