Trading Tools to Build Your Portfolio: Collaring Human Genome Sciences (HGSI)

              

In last week's edition of Trading Tools, we examined eBay Inc. (EBAY), after the Zacks Unusually High Option Volume screener revealed that put writers were pummeling the stock ahead of earnings. Employing the same filter for today's column, a different security piqued my curiosity: Maryland-based biopharmaceutical behemoth Human Genome Sciences (HGSI: sentiment, chart, options).

For an explanation of the contrarian stance that makes Schaeffer's so unique, check out a recent version of Trading Tools.

The Data

According to the Zacks screener, option bettors from both sides of the Street bombarded HGSI on Thursday. More specifically, the security saw roughly 14,500 puts change hands, more than tripling its average daily volume of fewer than 4,600 contracts. On the flip side, the stock saw about 37,300 calls cross the tape, more than quadrupling its average single-session volume of fewer than 9,300 contracts.

On the put side, the most active option was the August 2.50 strike, with roughly 13,200 contracts traded. The out-of-the-money strike is now home to peak put open interest in the soon-to-be front-month series, with more than 54,200 contracts in residence. Meanwhile, the most active call yesterday was the August 5 strike, with more than 18,000 contracts changing hands. The out-of-the-money 5 strike is already most popular among August-dated option traders, harboring about 32,400 open call positions.

After further research, however, it seems some of the activity surrounding the August 2.50 put and August 5 call were related. Each option saw a block of 250 contracts cross the tape, both marked "spread." The 2.50-strike puts traded at the ask price of $0.78, suggesting they were bought. Meanwhile, the 5-strike calls traded at the bid price of $1.20, implying they were sold. Assuming both blocks were related (and the investor already owns at least 25,000 shares of the security), it seems we may have unveiled a collar position on HGSI.

The Strategy

The collar is a strategy best suited for traders who have seen a recent rally in a stock they already own, and want to protect their unrealized profits from a pullback. The option play is implemented by purchasing a protective put on a long stock position. The investor then helps to offset the cost of the put by selling a covered call on the same stock with the same expiration date. Typically, both options will be out of the money.

The investor's objective is for the underlying shares to be above the sold call strike at expiration so the stock is called away. If assigned, the trader can sell the shares at the strike price, locking in a profit over what he initially paid for the stock.

If the sold call is less expensive than the purchased put, the trade will be established for a net debit. In this case, the breakeven level on the collar is calculated by adding the net debit paid to the stock price at initiation. On the flip side, if the protective put is the least expensive of the two legs, the trade will be established for a net credit. In this case, the breakeven level on the position is calculated by subtracting the net credit received from the stock price at initiation.

At the time of initiation, the maximum profit potential of the collar is limited to the sold call strike minus the current stock price plus/minus the net credit/debit on the trade.

That being said, let's investigate the aforementioned collar on HGSI.

The Play

Since the puts were purchased for $0.78 and the calls were sold for $1.20, the collar was initiated for a net credit of $0.42 ($1.20 - $0.78). As such, the breakeven level on the trade is $2.93 (yesterday's closing price of $3.35 – net credit of $0.42). In other words, in order to avoid a loss on the play, the investor needs the stock to remain at or above the $2.93 level by expiration on Friday, Aug. 21.

If the shares of HGSI rally past the $5 level by August expiration, the 5-strike call will have a great chance of being exercised. The investor would then receive $5, or $500 per contract ($5 x 100 shares), for his shares of the stock – which we can only assume is more than what he originally paid. However, the strategist would no longer own the underlying shares, meaning he or she could miss out on significant portfolio profits if the equity skyrockets substantially higher.

On the other hand, if the shares of HGSI stutter below the $2.50 level by expiration, the trader could then exercise the August 2.50 put, selling his or her stock for $2.50 per share, or $250 per contract. By initiating the collar position, the investor has guaranteed a minimum selling price to unload his shares if necessary.

The Motive

Now that we've established the potential option play, it's time to explore the reasoning behind the collar strategist's need for portfolio protection. Most likely, the investor is hedging his bets ahead of the pharmaceutical firm's highly anticipated clinical trial results for experimental drug Benlysta, which are expected to hit the Street on Monday.

Analysts are skeptical of the drug's success, citing disappointing early trial results of the lupus treatment. Furthermore, it's been more than 30 years since a new lupus therapy has been approved, according to a recent Reuters article. As such, a Barclays analyst gave Benlysta only a 15% chance of success in its late-stage trial, while a broker at UBS viewed the drug "with cautious skepticism."

The Charts

While the brokerage bunch may be wary ahead of the trial results, investors have boarded HGSI's bullish bandwagon. Since grazing the $0.50 level in mid-March, the shares have powered more than seven times higher, with help from their ascending 10-week moving average. What's more, during the past 60 trading sessions, the equity has outdistanced the broader S&P 500 Index (SPX) by an impressive 144%. At last check, the equity was lingering in the $3.50 neighborhood, and is poised to close the week atop its 50-month trendline for only the second time since January 2008.