The Health Care Sector Select SPDR ETF (XLV) has been on a steady upward climb since Aug. 31, 2011 when it closed at $31.73. XLV traded as high as $76 on Aug. 1, 2016 and closed at $68.96 on Nov. 28, 2016. It has more than doubled over five years. Johnson & Johnson (JNJ) is the largest component of XLV at 12.28%. The healthcare sector has seen a great deal of volatility since the implementation of the Affordable Care Act (ACA) (Obamacare) in 2009 and the 2016 presidential election, more recently.
Gilead Sciences (GILD) comprises 3.76% of XLV, has a market cap of $98 billion and a PE ratio of 6.88. By comparison, Pfizer Pharmaceuticals (PFE) has a market cap of $194 billion and a PE ratio of 31.67. On June 5, 2011 GILD closed at $19.50. On June 24, 2015 GILD traded as high as $123.37. April 28, 2016 was the last time that GILD traded above $100. GILD traded as low as $71.39 this November closing the month at $73.70. It’s possible that the cupboard is bare for GILD’s new products, which results in the disparity between the two PE ratios. It is also possible that GILD is simply oversold.
With GILD trading at $74.86, the February 90 calls are trading at 0.32 while the February 60 puts are trading at 0.34 — roughly the same price. As a comparison, with SPY trading at 220.85, the February 240 calls are trading at 0.17 while the February 200 puts are trading at 1.52. In this instance, there is a wide disparity between the equidistant out-of-the-money (OTM) calls and puts.
Why is this? Historical volatility is the realized volatility of an underlying product during a specific period. It shows how much movement there has been and how rapidly that movement was in either direction. Implied volatility is the reverse engineering process where you take the current price of the premium and figure out how much movement is implied until the end of the expiration cycle. Historical volatility is in the past and implied volatility is a prediction of future movement.
Options traders are rational actors. When the OTM calls are priced much lower than the equidistant OTM puts that indicates that the underlying product moves much more rapidly to the downside than to the upside.
If it’s a slow climb to the upside, then there will be light demand for the OTM calls. If it’s moving slowly, you can always snatch up the calls at a later date.
If the moves to the downside are rapid, then the OTM puts will have exploded before you have a chance to buy them. That is what is known as the options skew.
SPY is positively skewed to the downside and negatively skewed to the upside. That is, the implied volatility decreases with the higher strike prices and increases with the lower strike prices. You would never want to buy a ratio spread in SPY where you buy more calls at a higher strike price than you sell calls at a lower strike price. The demand for time value decreases as the price of SPY increases.
GILD, though, has a relatively flat skew. It moves with equal speed to both the upside and the downside. A ratio spread is therefore neither inherently favorable nor unfavorable. If you’re bullish on GILD then let’s look at buying 20 GILD February 85 calls at 0.73 and selling 10 GILD February 80 calls at 1.62 with GILD trading at $74.86.
This can be done for a credit of $160, which will be your profit at expiration if GILD closes at $80 or lower. Above $80, the position loses money until it hits its breakeven point at $89.94. Its maximum loss of $4,840 occurs at $85. That is when GILD is as high as it can be when the February 85 calls are still worthless (“Profit & loss”). For this spread to work really well, the quicker that it moves to the upside the better. It will make around $2,000 if GILD moves there within the next week. Time works against this position to the upside so adjustments need to be made as time goes by.