Harness Biotech Volatility With An Options Strategy: Theta Strategy Capital's Eden Rahim

TM editors' note: This article discusses a penny stock and/or microcap. Such stocks are easily manipulated; do your own careful due diligence.

Volatility is the nature of the biotech beast, and it must be tamed or utilized to advantage. That's the philosophy of Eden Rahim, portfolio manager and option strategist at Theta Strategies Capital. Can you grow a portfolio if some of your more successful names are called away by option buyers before the stock goes into the stratosphere? The answer is yes, and in this interview with The Life Sciences Report, Rahim describes his technique and leaves readers with six names that he fully expects to reap very large gains.

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The Life Sciences Report: You are CEO and cofounder of Theta Strategies Capital, and also the portfolio manager and innovator of the Next Edge Theta Yield Fund, which derives income from the options strategies you have developed over two decades. These strategies profit, in part, from the decline in pricing that occurs as options approach expiration. Could you describe that strategy?

Eden Rahim: Yes. My partner, Mike Bird, and I formed Theta Strategies Capital a couple of years ago to provide institutions with income and hedging solutions using option strategies as an advantage. We thought we would be able to add yield to institutional portfolios, dampen volatility and protect against downside. We have designed and traded a variety of strategies through virtually every crisis in the past couple of decades.

In January, we launched a prospectus fund called the Next Edge Theta Yield Fund. Essentially, what we do is exploit the mathematical property of all options to lose value with the passing of time. That property is called theta. If you own an option, it loses a little bit of value every day, regardless of the underlying security or index. We first conceived of this fund back in 2002, and thought of it as a novel way to provide yield. Bond investors are always trying to pick the best income funds. We created a yield product that exploits strategies option market makers use, and we brought that to average investors through this prospectus-based fund.

TLSR: So, at least with your income fund, you don't care which way the market is going?

ER: No. Our mandate is agnostic. We don't rely on forecasts and market direction. We're not trying to predict whether the market will go up or down, as a traditional fund would do. We know the market is going to do whatever it wants to do. We can't control that. The Theta Yield Fund basically holds 90–95% cash, and we invest in limited-risk option spreads that exploit time to expiration.

TLSR: As simply as possible, give me an example of how writing an option works for you.

ER: Sure. We use a variety of risk-defined strategies, one of them being a call calendar, for example. Let's say the S&P 500 is sitting at 2,100 right now. A one-month call option trades at about $25, and it loses value, or decays, about $0.60 a day. A two-month option with a 2,100 strike price costs $40, or 60% more, but that option loses only $0.40 a day. So the longer-dated option loses less value each day than the shorter-dated option. If you short the one-month option at $25 and buy the two-month option with a 2,100 strike at $40, it costs you $15, but with the whole position, you benefit by a gain of $0.20 a day. You're not making a market call because you're long and short at the same strike price. All you're doing is exploiting that property of options to lose value, and you benefit from it. Again, exploiting that property is what we call a theta strategy.

TLSR: Why do you hold so much cash in the Theta Yield Fund?

ER: We only write premiums equal to 2–3% of the net asset value (NAV) of the funds because we're not there to hit home runs. We're just trying to hit singles for average. We want to have very low volatility. We want to be agnostic to market changes.

We could obviously have higher returns. The goal is to earn about 0.5% to 1% per month, with very low volatility. If we do that, the fund earns its stripes.

TLSR: Let's talk about your Bio-Tech Plus Fund. It's a growth fund. Do you hedge this fund? You limit your upside that way, don't you?

ER: Yes. That's a great point. I do hedge the portfolio. And that does, at times, limit the upside of the portfolio, but with the key ancillary benefit that it also limits the downside exposure. You and I both know that with biotech, it can be up by the escalator, then down by the elevator at times. During this five-year bull, in 2010, 2011 and 2013 we had 15% corrections, and in 2012 and 2014 we had 25% corrections. And yet the bull goes on. It's just par for the course in the sector. Even this year, in March and April we had 10% selloffs from the peak to the trough, all within this bull move. That's just natural to biotech. We accept it for what it is, and we take steps to dampen that volatility because we're counting on stock picking to deliver our returns.

One of my holdings is Inotek Pharmaceuticals Corp. (ITEK:NASDAQ). It's up more than 100% in a very short period, and that one position adds about 1% return to the fund. I rely on stock picking for excess returns, and then I try to dampen the sector volatility with hedges and written calls. That's the philosophy behind it.

TLSR: Eden, you have some stocks in the Bio-Tech Plus portfolio that range from $20 million ($20M) to $60M in market cap. These are true micro-cap stocks. You also have some small caps, in the $200–300M range. But you can't write options on the very small names, can you?

ER: No. Most of the options we have written are in the mid-cap area. I've written calls against Acadia Pharmaceuticals Inc. (ACAD:NASDAQ), Amicus Therapeutics Inc. (FOLD:NASDAQ), Halozyme Therapeutics (HALO:NASDAQ), Portola Pharmaceuticals (PTLA:NASDAQ), Raptor Pharmaceutical Corp. (RPTP:NASDAQ), Supernus Pharmaceuticals Inc. (SUPN:NASDAQ) and Synergy Pharmaceuticals Inc. (SGYP:NASDAQ). They're in the $1–2 billion ($1–2B) range. Each of those are roughly 1.5–2% weights in the fund. And they have all had big moves. I'm trying to hold them for the long term, but when they get extended and move far above their moving averages in a short period of time, as some of them have, I will write options.

Every once in a while you miss it and a company might move higher, like Ultragenyx Pharmaceutical Inc. (RARE:NASDAQ). I sold options on my Ultragenyx position at $100 after it moved up from $54, but it then went to $127. It was crazy. I did leave some upside on the table there, but you don't know these things in advance. Ultragenyx could just as well have fallen back to $90 or $85.

Over time, options just add an extra form of defense for our unit holders because nothing grows to the sky. When these stocks move far above their 50-day moving averages, I'll write the options.

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Disclosure:

1) Dr. George S. Mack conducted this interview for Streetwise Reports LLC, publisher ...

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