I’m ‘Following Up’ on a Biotech Trade With Attractive Potential

Just before noon ET on Friday, May 27, Doug Kass posted the following in his Daily Diary on Real Money Pro: 

“I added to SPDR S&P Biotech ETF (XBI)  this morning.

And I sold some attractively priced calls against it.”

This piqued my interest. 

I have been slowly adding to my XBI holdings via covered calls for several months now. I have no doubt this will be a good trade over the long run, but Doug is more renowned for his market timing than me so I followed him into this trade on Friday with some additional buy-write orders on the XBI.

There are several reasons to believe the XBI has indeed finally hit a bottom after falling some 60% from where it began 2021. First, from a technical perspective, the ETF seems to have formed a bottom here in the back half of May.

Second, the small and mid-cap biotech space has gotten more than dirt cheap. Take Graphite Bio (GRPH) , for example. This early-stage gene-editing developmental concern has been beaten down to the point where it has an approximate $130 million market capitalization. As of the end of the first quarter, the company had approximately $350 million in net cash on its balance sheet. Graphite Bio is one of hundreds of small biotech stocks trading at levels below the cash on its balance sheet at the moment.

The only similar occurrence I can recall in any sector like this was around small internet stocks at the end of the Internet Bust. I remember picking up a small search engine company called Ask Jeeves (ASKJ) in either late 2001 or early 2002 for two bucks a share. It had $3.75 a share in net cash on its balance sheet at the time. In 2005, it was bought out for $26.00 a share.

A similar cheapness across the biotech sector is starting to trigger a pickup in M&A transactions. Most of these are small in nature for the moment, but they are likely to increase significantly in the back half of 2022. Big Pharma certainly has a huge amount of cash and financial flexibility to expand their footprint in oncology, rare disease, CNS and other niches of the market in a major way.

How can an investor take advantage of this?

Given the beating biotech has taken in recent quarters, an investor is likely to make more through year-end buying solid individual biotech stocks if we manage to have just a neutral investment environment going forward. However, the following trade provides a more than solid return and offers significant risk mitigation and diversification.

Option Strategy

Here is how one can initiate a position in XBI via a covered call strategy. Covered call orders involve buying an equity and simultaneously selling just out of the money call strikes against the new position.

Using the December $70.00 call strikes, fashion a covered call order with a net debit in the $60.20 to $60.40 a share range (net stock price – option premium). This strategy provides 15% of downside protection as just over that as potential upside even if the stock declines a bit over the option duration.

(Please note that due to factors including low market capitalization and/or insufficient public float, we consider GRPH to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.)

(Bret Jensen is a regular contributor to Real Money Pro. Click here to learn more about this dynamic market information service for active traders and to receive daily columns and trade ideas from Paul Price, Doug Kass, Peter Tchir and others.)