Bulls Prove Immune to Biotech Rout With Bets on Rebound: Options

The worst week for biotechnology shares since 2011 did little to dissuade bullish investors. In fact, it provided them with a prime buying opportunity.

While the iShares Nasdaq Biotechnology ETF tumbled 6.8 percent last week, traders piled into options betting on a rebound. A daily average of almost 8,600 calls changed hands on the exchange-traded fund in the past five days, the most since 2008, data compiled by Bloomberg show. The cost of bullish contracts climbed to the most expensive level in four months versus bearish ones. That turned out to be a wise bet considering the ETF has jumped 5.3 percent in the last two days.

The selloff opened the door for new money by giving investors a chance to buy pricey biotechnology shares at a discount, according to BMO Capital Markets Corp.’s Max Breier. With companies from Endocyte Inc. to InterMune Inc. discovering new treatments for lung disease and cancer, traders are betting that the industry will keep generating the best gains in the stock market after the ETF doubled in the past two years.

The jump in call volume shows investors “are trying to pick the bottom in biotech,” Breier, a senior equity-derivatives trader at BMO in New York, said in a March 31 phone interview. “They’re trying to play a continuation of what’s a longer-term bullish trend.”

Stocks Recover

The Nasdaq Biotechnology Index is rebounding from losses last week as traders buy up shares that were hit the hardest in the selloff. While the index has slumped 12 percent from its record high in February, it’s still up 6.4 percent this year. The gauge climbed 0.1 percent at the close in New York.

Losses across the industry were triggered by drugmakers facing scrutiny over how much they’re charging patients and insurers. Gilead Sciences Inc. was asked by U.S. House Democrats last month to explain the $84,000 price for its hepatitis C treatment Sovaldi. The shares slid 9.2 percent over the following six days.

Alexion Pharmaceuticals Inc. tumbled 14 percent in March as U.K. regulators inquired about the cost of Soliris, its $569,000 a year rare-disease drug.

Speculation that the decline was overdone lured investors to bullish options. Calls with an exercise price 10 percent above the Nasdaq Biotechnology ETF cost 6.23 points less than puts betting on a similar drop, the smallest gap since November, according to three-month data compiled by Bloomberg.

Calls cost an average 7.18 points less than puts in the past year, the data show.

Attractive Entry

“There may be limited room for fall from current levels,” Robyn Karnauskas, an analyst with Deutsche Bank AG, wrote in a March 31 note to clients. “Strong fundamentals and current weakness create an attractive entry point.”

Celgene Corp. slumped 13 percent last month, even after winning U.S. approval of a pill to treat psoriatic arthritis, a painful joint condition that occurs in about 30 percent of the 125 million people worldwide who have psoriasis. Among the 10 most-owned options on the stock, eight are bullish.

For Mylan Inc., calls are more expensive than puts for the first time in five years. Earnings at the biggest U.S. generic drugmaker will increase 20 percent in 2014, more than double the pace of companies in the Standard & Poor’s 500 Index.

Some investors still see biotechnology shares as overvalued even after the selloff, said Lillian Seidman of Miller Tabak & Co. The group trades near the most expensive level in the past decade, with a price-earnings ratio of 35.7 excluding companies with losses. Less than 30 percent of companies in the Nasdaq Biotechnology Index are profitable, according to data compiled by Bloomberg.

Ridiculous P/E

“There’s no other sector that’s moved up so much, and possesses the greatest amount of risk to the downside,” Seidman, an options strategist at Miller Tabak in New York, said in a March 26 phone interview. “There’s a camp that will talk about the ridiculous P/E multiple, saying that it’s not justifiable.”

Investors that ignored price-earnings ratios and speculated on drug trials and regulatory decisions have reaped rewards. Endocyte, a biotechnology company with no marketed products, is up 119 percent this year after a study showed its experimental medicine slowed the progression of lung cancer.

InterMune, which isn’t expected to be profitable this year or next, is the second-best stock in the Russell 2000 Index with a 131 percent surge for 2014. The company said in February that its drug pirfenidone for a fatal lung disease met goals of a study expected to support U.S. approval.

Buying Calls

Options on biotechnology stocks are expensive partly because of increased demand for bullish bets, BMO’s Breier said.

Implied volatility, used to gauge the price of options, on the biotechnology ETF reached 32.02 last week, the highest since October 2011. That compares with 12.14 for the SPDR S&P 500 ETF Trust, according to data compiled by Bloomberg on three-month contracts closest to the shares.

“People are wary of holding the stock, so they are buying calls to play the high-beta turnaround,” Igor Biselman, an equity-derivatives trader at Cowen & Co. in New York, said in a March 31 phone interview. “Portfolio managers have been looking to sell their stock and replace them with calls in order to still get upside exposure with limited downside risk.”

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