This Triple-Digit Stock Could Make Traders Up to 150%
Opportunity cost is one of the biggest reasons investors fail to pull the trigger on buying shares of a company they think might be going up. Once you commit to buying a stock, that money is tied up and could result in you missing out on any other opportunity that comes knocking. This is especially true with high-priced stocks.
Gilead Sciences (NASDAQ: GILD) is that kind of stock. It’s currently trading around $108 a share, which means buying 100 shares will cost roughly $10,800 — a tough initial outlay even for a stock you have high hopes for. With options though, you can take advantage of the upside to this company without having to shell out 10 grand.
One of the bigger biotech companies with a market cap of more than $160 billion, GILD has performed well in 2014 — up 44% year to date. Its larger size and revenue from existing drugs allows it to absorb the heavy upfront costs associated with new drug research and development.
The stock slipped last week on the news that Gilead is teaming up with several generic drug manufacturers to create a low-cost version of its trademark hepatitis C drug Sovaldi to bring to developing countries. Investors feared this would lead to blowback from its domestic pricing. Sovaldi costs $84,000 for a 12-week treatment in the United States.
However, the strategy of lowering costs in low-income markets isn’t new to the industry. Consider the reduced cost of HIV medication in other parts of the world. And I view any temporary weakness in the stock as a buying opportunity.
Long-term EPS growth for the company is expected to be around 25% a year. The PEG ratio compares a stock’s price-to-earnings-to-earnings (P/E) ratio to its EPS growth ratio, with 1 considered to be fair value. A low PEG valuation could indicate that a stock is currently undervalued. With a P/E ratio of 11.6 based on next year’s earnings, GILD has a PEG ratio of just 0.46, signaling buying here represents a discount.
Furthermore, with year-over-year quarterly earnings of 373% and operating margins of 56%, GILD has plenty of breathing room in a difficult economic environment.
Finally, a key ratio to pay attention to in the biotech sector is the cost of research and development (R&D) to revenue. The higher the figure, the more is being spent on new products instead of collecting income from previous successful ones. Gilead’s cost of R&D to revenue is less than 9% compared to competitors like Merck (NYSE: MRK) and Pfizer (NYSE: PFE), which stand at 15% and 14%, respectively.
Based on next year’s earnings expectations of $9.36 per share and the stock’s historical average P/E ratio of 16, GILD could be worth around $150. Using a bull call spread, we can take advantage of this discounted pricing at just a fraction of what it would cost to buy the stock outright.
To initiate a bull call spread, we simultaneously buy one call option and sell another with the same expiration date but a higher strike price. The option premium from the call sold decreases the cost of buying the long call.
Recommended Trade Setup:
— Buy GILD Nov 105 Call near $8.55
— Sell GILD Nov 120 Call near $2.70
— Enter trade at net debit of $6 or better
The most appealing part of using a bull call spread is the cost reduction required to invest. The initial capital outlay will be just $600 or less per contract, which controls 100 shares. Compare that to the $10,800 it would take to purchase 100 shares of GILD.
Our breakeven for this strategy is the strike price of the long call ($105) plus the net debit paid ($6), or $111, which is less than 3% above GILD’s current price. If the stock does not rise above $111 by the time these calls expire on Nov. 22, we will experience a loss. However, the maximum loss is limited to the $600 or less paid to initiate the trade, while someone who purchased 100 shares of the stock could realize a theoretical maximum loss of $10,800.
Like our downside, our upside is similarly limited with a bull call spread. Once GILD reaches the strike price of the call sold ($120), anything above and beyond won’t count, as shares will be sold at that price. In effect, the stock is bought at the lower strike of the long call and sold at the higher strike of the short call.
The maximum profit is therefore the difference between the two strike prices ($120-$105 = $15) minus the net debit ($6), or $9 ($900 per contract). This means we can realize up to a 150% return on our investment.
Using a bull call spread allows us to leverage 100 shares of a high-cost stock for just a fraction of the cost of buying shares outright. If GILD rises to $120 by expiration, gaining just under 11%, the spread will net us 150%. That’s quite a difference, especially considering we’re drastically reducing our downside risk.