Options Update: A Calendar Spread on Teva Pharmaceuticals?
Israel-based Teva Pharmaceuticals
(
TEVA |
Quote |
Chart |
News |
PowerRating) has been in the headlines quite a bit recently. The company reported ill-received second-quarter earnings on July 29, and announced that it was acquiring rival Barr Pharmaceuticals (BRL) on July 18. This morning, Teva extended its run in the headlines by announcing that its Parkinson’s drug AZILECT (R) hit all 3 of its Phase III endpoints.
According to one of the principal investigators of the trial, Professor Oliver Rascol M.D., Ph.D., Department of Clinical Pharmacology, “The rigorous trial design and the fact that all three primary endpoints were met with statistical significance reinforce the quality of the data, supporting the potential for AZILECT(R) to have an effect on disease progression.”
Whether sparked by today’s news, or the pending acquisition of rival Barr, options traders are piling into call options this afternoon. In fact, more than 7,500 calls have changed hands, more than quadrupling TEVA’s average daily call volume and placing the stock on today’s Intraday Volume Explosion List. While this trading activity was certainly notable, it was the 3,590 contracts crossing at the stock’s September 47.50 call and the 3,050 contracts trading on the October 47.50 call that caught my eye today.
Anatomy of a Calendar Spread
Digging into the activity, I discovered that 2 large blocks of 3,000 contracts traded on both the September 47.50 call (TVQ IW) and the October 47.50 call (TVQ JW) at about 9:55 a.m. Eastern time on the American Exchange (AMEX). Given the same block size, time of the trades, and the exchange information, I speculated that this could be the initiation of a calendar spread. For reference, a calendar spread involves the sale of an option with a nearby expiration and the purchase of an option with the same strike price, but a more distant expiration.
Looking more closely at these TEVA trades, I noted that the TVQ IW contracts changed hands at the bid price of $1.10, while the TVQ JW contracts traded between the bid and ask price. While the questionable price on the October 47.50 option calls into question whether or not the these contracts were purchased, the other surrounding factors lead me to believe that this is mostly likely a calendar spread.
Running with this theme, this hypothetical calendar spread involves selling a near-term call and the purchasing a back-month call, both at the same strike. This results in a net debit to the investor’s account, but is viewed as offsetting the cost of buying the back-month option outright. The maximum profit is achieved as long as the sold call stays out of the money by expiration, and the stock rallies above the purchased call before the longer-term option expires. In today’s example, the hypothetical trader needs TEVA to stay below 47.50 through the close of trading on September 19, and then rally above 47.50 by the close of trading on October 17.
So, how does today’s example work on paper? First, the trader sells the TVQ IW calls for a credit of $330,000 — ($1.10*100)*$3,000 = $330,000. Next, the trader buys the TVQ JW calls for a debit of $525,000 — ($1.75*100)*3,000 = $525,000. A total debit of $195,000 for the position is arrived at by adding the credit received from selling the September 47.50 calls ($330,000) and the debit incurred for purchasing the October 47.50 calls (-$525,000) — $330,000 – $525,000 = -$195,000.
Offsetting the Cost
So, why not just buy the October 47.50 calls outright? Well, the sold September 47.50 calls help to offset the cost of the purchased October 47.50 calls. Specifically, the TVQ JW calls have a much lower breakeven threshold due to the sold September contracts. Normally, for the October 47.50 call to breakeven, TEVA would have to rally to $49.25 (47.50 + 1.75 = 49.25). However, subtracting the premium received for the sold TVQ IW contracts (1.75 – 1.10 = 0.65) places breakeven for the trade at $48.15 (47.50 + 0.65 = 48.15). Finally, the maximum loss for this credit spread is limited to the amount paid at open, or $195,000.
So, by entering this position the hypothetical trader is looking for TEVA to rally about 2.5% before the back-month option expires on October 17. Let’s see if the stock’s technical picture or sentiment backdrop offer up any clues on the potential for the shares to rally…
Technically Speaking
From a technical perspective, TEVA has all but flat lined after posting a solid rally along its 10-week and 20-week moving averages last year. Since January 2008, however, the shares have remained largely range-bound between support in the 44-44.50 area and resistance at the 49-50 region. The 50 level halted TEVA’s year-long rally in December 2007, and thwarted another rally attempt in late February.
But the picture has begun to improve recently, with the shares up more than 16% since their mid-July bottom. What’s more, the stock has pulled its 10-week and 20-week trendlines into a bullish cross – a technical formation that often indicates continued outperformance over the intermediate term. Since an intermediate-term gain is exactly what the credit-spread trader is looking for, this configuration supports a potentially positive outcome for this position.
The Sentiment Drivers
Sentiment toward TEVA isn’t quite as supportive from a contrarian perspective. Short interest accounts for a mediocre 4.58% of the stock’s total float, providing some (but not overwhelming) potential for a short-covering rally on any additional positive news from the company. Meanwhile, Wall Street is heavily bullish, with Zacks.com reporting that 6 of the 11 analysts following TEVA rate the shares a “buy” or better. Downgrades could be a concern for the shares, especially if AZILECT (R) news proves to be not quite as convincing as hoped.
On the other hand, options activity provides some upside bias for the credit-spread position. TEVA’s Schaeffer’s put/call open interest ratio (SOIR) rests at an uninspiring reading of 0.74 in the 43rd percentile of its annual range, but the stock’s open interest configuration is more promising. Peak call open interest for the September series resides at the 47.50 strike, and could limit TEVA’s upside over the short-term. However, this hurdle is clearing in the October series. While option activity is light for the back-month so far – it just began trading on August 18 – most of the attention is focused on the 50 call. With the 47.50 region potentially losing a bit of influence from the options crowd, the likelihood of TEVA reaching the needed breakeven mark of $48.15 seems more likely once September options expire.
The Verdict?
The setup for this bullish outlook on TEVA has some merits. The technical picture is hopeful, with the stock benefiting from bullish momentum in the shares price. However, the sentiment outlook has me a bit concerned, as the wealth of optimism from analysts is a potential liability for TEVA. Still, we are dealing with a pharmaceutical company with key pipeline drugs currently in trials, providing TEVA with a relatively high level of volatility. If you can stomach the risk involved with trading bullish positions on such a company, why not offset that risk with a calendar spread? It works well with the Pepto, after all.
Did you know that you can get headlines for my articles emailed directly to you? If you’d like to take advantage of this service, simply go to www.Schaeffersresearch.com and sign in with your Schaeffer’s username and password. Once on the alerts page, select author from the first drop down box, select how often you want to be alerted (intraday, daily, weekly, or monthly), and enter Joseph Hargett into the third box.
Newly revised and updated, Bernie Schaeffer’s home study program, “10 Days to Successful Options Trading,” provides a foundation for your options trading success. Includes easy-to-follow guide, CD, DVD, and a special report — Click here to learn more.
Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.