Playing Bio-Reference Labs With Options

Editor's Note: This column has been updated to further address Opko Health's announced acquisition of Bio-Reference Labs in a deal valued at about $1.5 billion. Traders often look at option action to get a feel for where an underlying security might be heading. If people are paying up for OTM (out-of-the-money) call options, perhaps they know something. That reasoning sounds logical, but it doesn't really hold up to scrutiny. Many times put options on the same stock are trading for generous premiums based on the exact same expiration date. If the person buying calls knew the stock was going to go up, what would that say about the speculator betting on a decline by the same date? Anything is possible between now and the time of expiration, but, at 4 p.m. on that date, if the stock in question closes above a certain strike price, it cannot also be below it. Either, or neither, of the option buyers might end up making money. It is a certainty, though, that at least one of them must be wrong in the end. That presents opportunity for option sellers. After finding a stock you like, selling both covered calls and naked puts can go a long way towards reducing risk while lowering your initial net cash outlay. Bio-Reference Labs (BRLI) was trading for just under $33 on June 3. The stock looked reasonably cheap at 16.4x this year's expected earnings of about $2 per share. Opko Health (OPK) announced Thursday it has agreed to buy Bio-Reference Labs in a deal valued at about $1.5 billion. Opko will pay 2.75 shares for each Bio-Reference Labs share, equal to about $52.58 per share. The deal is expected to close in the second half of this year. Sales, book value and profits have never been higher. The health care industry has been the hottest group stretching back over the past five years. Takeover rumors have been floating around on rivals Lab Corp (LH) and Quest Diagnostics (DGX) on a periodic basis. BRLI appears to be a low-risk play at its current quote. I picked up some BRLI shares and was able to sell Nov. 20, 2015, $35 calls at $1.70 per share and Nov. 2015 $32.50 puts at $2.25. Both sets of options were OTM as of trade inception. Here are the actual trades as of mid-afternoon on Wednesday. There are three possible outcomes once the 169 days (5.63 months) until Nov. 20, 2015 have passed. 1) BRLI may rise to $35 or higher 2) BRLI could remain between $32.50-$34.99 3) BRLI might finish below $32.50. The potential results shown below assume the trades are executed in a margin-type account using existing equity to meet margin requirements on the put. An approximately 6% increase in price would translate into a better than 20% net profit, achieved in less than half a year. That is equivalent, percentage-wise, to a move to $39.58 for an outright buyer at $32.99. Making more than 13% in under six months on an unchanged stock doesn't sound too bad. Any upward movement towards $35 would make the rewards better. Bio-Reference could go down. If it drops under the $32.50 strike price of our put, we'll be forced to double our position size, but at an average price well below where we first started. The first 6.7% of any decline would be absorbed by the sum of the two option premiums received up front. There is no guarantee we'll come out unscathed, but it's comforting to know that BRLI's year-to-date low was $30.74, just $0.03 under our break-even point. Trades like this are a great way to play tough markets while still leaving yourself very decent upside prospects. Update When I originally wrote this piece, the prices indicated were the actual trading prices available Wednesday afternoon. I traded those options, at those prices, yesterday. Earlier today, after Opko announced a share-based buyout of Bio-Reference Labs at a large premium to yesterday's closing price, trading in BRLI was initially halted in the premarket and then resumed. The stock rose substantially, and continued to do so in the regular session. That meant that all prices specific to the example in my article were no longer in play. But the buy-write technique described is still applicable to any stock that meets the criteria of having decent upside without big risk -- it applies to hundreds of stocks, even in today's market environment. Market prices can move rapidly even in the absence of takeovers. Always check to see if market-based or company-specific news has been released before trading any ideas presented here or on any other website.

Playing Bio-Reference Labs With Options

Selling covered calls and naked puts can reduce risk. (Updated)

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