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Strategy Definitions

Submitted by Biotech Team on Thu, 01/26/2012 - 19:23.

Disclaimer: Trading Securities is Risky. A trader is subject to this risk and can lose money. Please read the "Terms of Use Section" of the BioltechnologyEvents.com website prior to any and all uses of the content contained on the pages of the Biotechnologyevents.com website. http://www.biotechnologyevents.com/node/29

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The BiotechnolgyEvents.com database is an an excellent resource for tracking the very important "events" that often mark inflection points in the life of a biotechnology company. In addition to this database, the website makes "event information packages" available which have been developed to provide the user with more in depth information regarding these events. The following sections outline a variety of investment strategies that may be used in conjunction with the preceding offerings.

The Strategy Menu is divided into several segments encompassing several Strategy types. The strategies outlines include: Bullish Strategies, Bearish Strategies, Volatility Strategies and Neutral or Non-Directional Strategies.

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OPTION STRATEGIES

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Bullish Strategies:

1) Long Equity or Call Option Position - The investor is Very Bullish on the outcome of the event and the prospects for the company. Buying call options offers the protection of limited downside loss with the benefit of leveraged gains.

The investor should consider using stop orders, married puts or other hedging strategies to manage risk.

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2) Short Bull Ratio Spread or Call Back Spread - The investor is Very Bullish on the outcome of the event and the prospects for the company and believes that the stock price will move significantly higher.

The investor will write (sell) an In The Money (ITM) call option and use the proceeds to purchase a greater number of At The Money (ATM) or Out of The Money (OTM) call options on the same underlying stock, with the same expiration month. Both the buy and the sell sides of this spread are opening transactions.

The ratio of long and short call options depends largely on the preference of the individual trader. A common ratio is the 3:1 ratio spread where you sell to open 1 ITM call option for every 3 ATM or OTM call options that are purchased.

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3) Bull or Vertical Call Spread - The investor is Moderately Bullish on the event. The investor believes that the price increase will be moderate and is comfortable with the risk of missing profits associated with a larger than anticipated move to the up side.

The investor will purchase a call option on a particular underlying stock, while simultaneously writing (selling) a call option on the same underlying stock with the same expiration month but at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. They can be purchased in a single transaction.

The main advantage is that the investor is able to purchase his or her call at a discount because of the premium (credit) from the sale of the contract with the higher strike price. Another advantage is that the investor is partially hedged against the risk of losing the entire premium paid for the long call. This mitigates, to a degree, a negative outcome for the event or the case of a non-event (postponement of a decision by the FDA to a date beyond the life of the option contract).

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4) Bull Ratio Spread - The investor is Slightly Bullish on the event. Like the Bull Call spread, the strategy employs the purchase of call options on a particular underlying stock, while simultaneously writing (selling) call options on the same underlying stock with the same expiration month but at a higher strike price. However, in contrast to the Bull Call Spread, the investor sells more out of the money calls at the higher strike price than he or she purchases at the lower strike price; this increases the amount of premium (credit) received from the sale and thus offsets to a greater degree the cost of the lower strike price call option.

The Bull Ratio Spread comes in three varieties: Debit, Free and Credit.

A Bull Debit Ratio Spread is established when the amount of call options that are sold do not cover the amount of money used on the long call options.

A Bull Free Ratio Spread is established when the amount of call options that are sold exactly covers the amount of money used on the long call options, thus resulting in no cash payment for the position.

A Bull Credit Ratio Spread or sometimes called a Call Credit Ratio Spread, is established when the total cost of the call options that are sold is more than the amount of money being paid on the long call options, thus resulting in a credit.

The position will start losing money if the stock rises past the strike price of the short call options. Theoretically, an extremely large increase in the underlying stock's price can cause an unlimited loss to the investor due to the extra short calls. However, if the stock falls instead of rises, then the maximum loss is limited to the net debit (if any). The maximum profit is achieved at the strike price of the short option.

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5) Bull or Vertical Put spread - The investor is Moderately Bullish on the event and will likely hold through the event to maximize profit as the price of the underlying stock increases or remains stagnant and the volatility associated with the event diminishes.

The investor will purchase an out of the money put option on a particular underlying stock, while simultaneously writing (selling) a put option on the same underlying stock with the same expiration month but at a higher strike price, typically one that is at or in the money. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. They can be purchased in a single transaction.

The investor will profit as the value of both puts diminish because the amount received for selling the put option with the higher strike is more than enough to cover the cost of purchasing the put with the lower strike price. This is called a credit spread because the net sale proceeds are larger than the net buy proceeds (cost), thereby bringing money into the investors account.

Note: As long as the short put option remains in the money, there is a possibility of it being assigned. You may then have to purchase the underlying stock to meet the short put obligation.

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6) Positive price momentum capture - The investor is only Slightly Bullish on the event. The investor holds a short term equity or call option position on the company with the intention of capturing any potential upside ahead of the key event. The investor sells the position before the event date and does not hold a long position through the event date. This strategy limits the risk associated with trying to predict the outcome of a binary event, (ex. positive or negative FDA decision, data release etc.) but takes advantage of the increased interest in the company as the event date draws near. If the investor is unsure as to the outcome of the event but predicts large volatility, he or she may consider following this strategy with a strategy that is bullish on volatility (Straddle).

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Caveats for Bullish Strategies:

The investor should make sure that the event in question is pivotal and will generate increased interest in the company; a small cap company that is looking at its first product approval or at a clinical data release that will validate a compound or technology can be appropriate if the market consensus is positive for a successful outcome. If the investor feels that there is significant doubt about the outcome, a bearish or volatility strategy should be considered (see below).

The investor should guard against a second event that could move the stock during the period in which the long position is to be held. Search the company for all events listed in the data base. Results will include all the relevant events for that company listed in chronological order. Please note, events such as earnings releases, conference calls and scientific conference participation can be found on the general event calendar.

The investor should also be aware of correlated events. Correlated events arise when two or more compounds are related by indication or mechanism. There are many "event types" that can be of impact, however the most common is clinical trial data, followed next by regulatory approval and agency opinion. The user can search by indication and add any important events within that disease space to the company specific events to achieve an even greater level of detail and comfort for the position.

The investor should be aware that event dates could have a third outcome - the postponement of an event to a later date - this is especially important if the new date is beyond the expiration date of an options contract. This scenario would result in a "volatility crunch" as the extrinsic value of the options (based on the expectation of the underlying stock moving on the event) dissipates quite rapidly.

The investor should consider using stop orders, married puts or other hedging strategies to manage risk. If an investor is long the call options, the purchase of a put may result in a new strategy that could be viewed as bullish on volatility or ambivalent regarding the event (see Straddle below).

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Bearish Strategies:

1) Short Equity or Put Option Position - The investor is Very Bearish on the outcome of the event and the prospects for the company. Buying put options offers the protection of limited loss if the stock moves higher and the benefit of leveraged gains.

The investor should consider using stop orders, married calls or other hedging strategies to manage risk. If an investor is long the put options, the purchase of a call will result in a new strategy that could be viewed as bullish on volatility, (see Straddle below).

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2) Short Bear Ratio Spread or Put Back Spread - The investor is Very Bearish on the outcome of the event and the prospects for the company and believes that the stock price will move significantly lower.

The investor will write (sell) an In The Money (ITM) put option and use the proceeds to purchase a greater number of At The Money (ATM) or Out of The Money (OTM) put options on the same underlying stock, with the same expiration month. Both the buy and the sell sides of this spread are opening transactions.

The ratio of long and short put options depends largely on the preference of the individual trader. A common ratio is the 3:1 ratio spread where you sell to open 1 ITM put option for every 3 ATM or OTM put options that were purchased.

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3) Bear or Vertical Put Spread - The investor is Moderately Bearish on the event. The investor believes that the price decrease will be moderate and is comfortable with the risk of missing profits associated with a larger than anticipated move to the down side.

The investor will purchase a put option on a particular underlying stock, while simultaneously writing (selling) a put option on the same underlying stock with the same expiration month but at a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. They can be purchased in a single transaction.

The main advantage is that the investor is able to purchase his or her put at a discount because of the premium (credit) from the sale of the contract with the lower strike price. Another advantage is that the investor is partially hedged against the risk of losing the entire premium paid for the long put. This mitigates, to a degree, a positive outcome for the event or the case of a non-event (postponement of a decision by the FDA to a date beyond the life of the option contract).

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4) Bear Ratio Spread - The investor is Slightly Bearish on the event. Like the Bear Call spread, the strategy employs the purchase of put options on a particular underlying stock, while simultaneously writing (selling) put options on the same underlying stock with the same expiration month but at a lower strike price. However, in contrast to the Bear Call Spread, the investor sells more out of the money puts at the lower strike price than he or she purchases at the higher strike price; this increases the amount of premium (credit) received from the sale and thus offsets to a greater degree the cost of the higher strike price put option.

The Bear Ratio Spread comes in three varieties: Debit, Free and Credit.

A Bear Debit Ratio Spread is established when the amount of put options that are sold do not cover the amount of money used on the long put options.

A Bear Free Ratio Spread is established when the amount of put options that are sold exactly covers the amount of money used on the long put options, thus resulting in no cash payment for the position.

A Bear Credit Ratio Spread or sometimes called a Put Credit Ratio Spread, is established when the total cost of the put options that are sold is more than the amount of money being paid on the long put options, thus resulting in a credit.

The position will start losing money if the stock decreases below the strike price of the short put options. Theoretically, an extremely large decrease in the underlying stock's price can cause an extremely large loss to the investor due to the extra short puts. However, if the stock increases instead of falling, then the maximum loss is limited to the net debit (if any). The maximum profit is achieved at the strike price of the short option.

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5) Bear or Vertical Call spread - the investor is Moderately Bearish on the event and will likely hold through the event to maximize profit as the price of the underlying stock decreases or remains stagnant and the volatility associated with the event diminishes.

The investor will purchase an out of the money call option on a particular underlying stock, while simultaneously writing (selling) a call option on the same underlying stock with the same expiration month but at a lower strike price, typically one that is at or in the money. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. They can be purchased in a single transaction.

The investor will profit as the value of both calls diminish because the amount received for selling the call option with the lower strike is more than enough to cover the cost of purchasing the call with the higher strike price. This is called a credit spread because the net sale proceeds are larger than the net buy proceeds (cost), thereby bringing money into the investors account.

Note: As long as the short call option remains in the money, there is a possibility of it being assigned. You may then have to purchase the underlying stock to meet the short call obligation.

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Caveats for Bearish Strategies:

The investor should guard against a second event that could move the stock during the period in which the short equity or long bearish option position is to be held. Search the company for all events listed in the data base. Results will include all the relevant events for that company listed in chronological order. Please note, events such as earnings releases, conference calls and scientific conference participation can be found on the general event calendar.

The investor should also be aware of correlated events. Correlated events arise when two or more compounds are related by indication or mechanism. There are many "event types" that can be of impact, however the most common is clinical trial data, followed next by regulatory approval and agency opinion. The user can search by indication and add any important events within that disease space to the company specific events to achieve an even greater level of detail and comfort for the position.

The investor should be aware that event dates could have a third outcome - the postponement of an event to a later date - this is especially important if the new date is beyond the expiration date of an options contract. This scenario would result in a volatility crunch as the extrinsic value of the options (based on the expectation of the underlying stock moving on the event) dissipates quite rapidly.

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Volatility Strategies:

Volatile Option Strategies also known as Back Spreads, are option positions that are constructed to profit when the underlying instrument moves either Up or Down. This kind of strategy is especially useful when the investor expects the underlying stock to move strongly but is uncertain as to which direction.

1) Long Straddle - the investor is confident that the event will take place and that it will result in a significant move in the underlying stock but he or she is unable to arrive at either a bullish or bearish conviction. The long straddle allows the investor to profit regardless of the direction in which the underlying stock moves.

The investor will purchase equal numbers of both - at the money - call and put options. The two options are bought at the same strike price and expire at the same time. The idea is that one leg of the position will profit significantly because of the very large move in its direction and the price appreciation achieved will be greater than the loss of premium that will result as the opposite leg is now very far out of the money. This position is of limited risk, since the most a purchaser may lose is the cost of both options.

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2) Long Strangle - like the straddle above, the investor is confident that the event will take place and that it will result in a significant move in the underlying stock but he or she is unable to arrive at either a bullish or bearish conviction. The long strangle allows the investor to profit regardless of the direction in which the underlying stock moves.

The investor will purchase equal numbers of both call and put options, however unlike the straddle, the strike prices will be out of the money and therefor differ. The two options are bought simultaneously and expire at the same time. The idea is that one leg of the position will profit significantly because of the very large move in its direction and the price appreciation achieved will be greater than the loss of premium that will result as the opposite leg is now very far out of the money. This position is of limited risk, since the most a purchaser may lose is the cost of both options.

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3) Long Gut - like the straddle and strangle above, the investor is confident that the event will take place and that it will result in a significant move in the underlying stock but he or she is unable to arrive at either a bullish or bearish conviction. The long gut allows the investor to profit regardless of the direction in which the underlying stock moves.

The investor will purchase equal numbers of both call and put options, however unlike the straddle and the strangle (at the money and out of the money respectively), both strike prices will be in the money.. The two options are bought simultaneously and expire at the same time. The idea is that one leg of the position will profit significantly because of the very large move in its direction and the price appreciation achieved will be greater than the loss of premium that will result as the opposite leg is now very far out of the money. This position is of limited risk, since the most a purchaser may lose is the cost of both options.

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Caveats for Volatility Strategies:

Volatility Crunch - A sudden, dramatic, drop in implied volatility resulting in a sharp reduction in extrinsic value and hence the price of options. This would occur if the event where to be postponed to a later date - this is especially important if the new date is beyond the expiration date of the options contracts. This scenario would result in the volatility crunch as the extrinsic value of the options (based on the expectation of the underlying stock moving on the event) dissipates quite rapidly. In the world of biotech one of the most common reasons for an event postponement is a delay at the FDA.

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Neutral Strategies:

1) Covered Call - The investor is neutral on the stock, believing that the company's shares will trade within a tight range. The investor seeks to take advantage of this trading range by selling calls on the stock, collecting the premium and then have the calls expire with little or no value as the result of time decay.

The investor holds a long position in the stock of the company and writes (sells) call options on that same asset in an attempt to generate increased income from the asset thus making a monthly income even when those stocks stay stagnant. The Covered Call can also be used to protect against a short term drop in stock price.

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2) Diagonal Calendar Call Spread - Like the covered call, the investor is neutral on the stock, believing that the company's shares will trade within a tight range. The basic idea of a calendar spread is to profit on the different rates of decay that exists between long-term options (LEAP) and short term options. Long term options will decay, or decline in value, at a rate slower than short-term option, all else being equal.

The investor will purchase an at the money long term option contract and sell an out of the money short term option contract. If the stock remains stagnant or trades within the tight range as expected, the short term contract will expire leaving the investor with the premium. This strategy is best employed when the investor believes, that over the long term the stock will eventually move higher. Thus the Diagonal Calendar Call Spread reaches its maximum profit potential only when the stock moves upwards and not when it is completely stagnant.

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3) Horizontal Calendar Call Spread - Similar to the Diagonal Calendar Call Spread, the investor is neutral on the stock, believing that the company's shares will trade within a tight range and a profit can be made taking advantage of the different rates of decay that exist between long and short term option contracts.

The investor will purchase an at the money long term option contract (LEAP) and sell an at the money short term option contract. If the stock remains stagnant the short term contract will expire leaving the investor with the premium. This strategy is best employed when the investor believes, that over the long term the stock will remain stagnant, when no change in the underlying price of the stock is expected; a situation when there are no events or catalysts in the foreseeable future.