Capitalizing on a Valeant Effort in a Mundane Market

I apologize for the title but I couldn’t resist. Valeant Pharmaceuticals International (TSE:VRX) continues to defy broader market complacency. The diversified pharmaceutical company has barely wavered in its price advance since August of 2014. While this trend may be getting a little long in the tooth, the question is whether there is a little more upside momentum to capitalize on. As of the close today (July 15, 2015) the shares have breached a historical high, closing at $304.67. Check out the chart below:

Now, if you think this stock is out of your price range, you may want to read on. I chose TSE:VRX to demonstrate how options can be used to take advantage of an expensive stock at a significantly reduced price. Let’s assume that we believe that the share price of Valeant (TSE:VRX) is likely going to re-test the previous high of $310.00 or perhaps higher over the next month. With the shares trading at $304.67 we may want to consider using a call option expiring in August with a strike price of $305.00. The last price for this option was $13.00 per contract. What an investor may want to take into consideration is that the short term target sits at $310.00. If the last price of the option contract ($13.00) is added to the strike price ($305.00), the break-even on expiration is determined to be $318.00. If the move happens quickly, it is possible for the long call position to be profitable. However, if the stock takes its time, or takes a detour, the probability of profiting is reduced. One way that we can lower our break-even point is by creating a Bull Call Debit Spread. This will lower the net cost of the trade and as a result, the break-even point.

The trade could set up as follows:

Buy 1 – August 305 Call $13.00
Sell 1 – August 310 Call $10.40
Net debit = $2.60

What we have effectively done is reduced the cost of participation even further by selling the out-of-the-money call and collecting the premium. While this limits the upside potential, the break-even point is now lowered to $307.60 which is determined by adding the newly adjusted cost of the trade to the 305 strike call.
In addition, the risk exposure has been reduced from $13.00 per share down to $2.60 per share. While the strategy has a limited upside, the investor has the potential to generate a 92% return on their risk should the shares be trading at or above $310.00 which is the strike of the written option contract.

This strategy is also an effective way to lock in profits on shares owned while continuing to participate in the stocks upside. Investors are often hesitant to sell their shares for a profit for fear that they may miss out on further upside potential. One solution is to sell the shares at a profit and replace stock ownership with the right to own the shares through the purchase of a call option or a Bull Call Spread.

The benefit of this is three fold:

-Investor locks in profits on shares owned
-Investor frees up capital to take advantage of new opportunities
-Investor may continue to benefit from further share appreciation with a limited risk exposure

I should mention that TSE:VRX is set to release earnings on July 23rd. An earnings report can have a very significant impact on the valuation of the company. This may not necessarily be in the direction of the primary trend. With that in mind, an option, or spread combination is a great way to trade your bias with a limited and defined risk exposure, especially on an expensive stock.