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7% Return, No Volatility

By

Deer, antelope, and Sammy?

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Professor John Succo wrote an article yesterday entitled "Zero Volatility" talking about taking the other side of the trade of option sellers. If you skimmed by it, please read it again and think about it for a while.

I have a good buddy who has built a nice biotech-only fund, largely from high net worth individuals. He's not adverse to running money for institutions or working with funds of funds, they are simply not interested.

So what's so different about his gig that the bigger players don't want to participate? He buys stocks. And holds them. This concept is apparently too radical and risky for most of the big money he's spoken with.

So what are the gorillas looking for? 7%, no vol. Translated, that means a 7% annual return (stick any percentage figure in there, really) and no volatility in the fund's asset value. Boiled down even further, they want to book gains without risking their money.

The ephemeral "free lunch" is apparently alive and well.

So how do these financial wizards manage to return their 7% without any volatility? They sell options to guys like John Succo and pray to the market gods the market stays in a trading range. They construct elaborate computer trading strategies to play miniscule differences between stocks, options, and the huge number of ETF's out there. They, and this is important for anyone who invests in biotech, "beta match" to try and flatten out any macro market moves.

Say a dev-stage biotech stock has a beta of three, meaning when the market moves it moves quite a bit more. They'll short that biotech to allow them to go long three, one-beta stocks. Since the stocks they are long are (theoretically) less volatile, they sell as many options as they can in order to generate their promised returns.

That dev-stage biotech stock they shorted? They'll dive heavy into the options on that one, too. They'll also use their (usually) considerable financial bulk to push the stock price around just about wherever they want to in these small capitalization, small volume names. This makes it easier to get good option premiums either to sell or use as a hedge.

Because they are short these biotech stocks, they cannot afford to see them jump in price. This has created a phenomenon I've written about before where good news will hike a stock 15-30% but bad news will drop it 40-60%.

John and I probably fundamentally disagree on the "proper" direction of the market. He's in Boo's camp and I am generally in Hoofy's camp. What we both agree upon is if this market decides to bust a major move, the resulting disconnect will be astonishing.

One thing most people don't realize about the 7%/no vol funds is exactly how short their leash is. The pension funds and funds-of-funds managers get daily (!) reports not on performance, but on volatility. Big volatility spike? Instant redemption. There is absolutely no patience involved.

At last December's American Society of Hematology (ASH) meeting in San Diego, I bet three sell-side friends dinner that the NASDAQ Biotech Index (NBI) would be up 50% in 2005. They laughed and gleefully took the bet. So far, I've got some serious egg on my face and expect to be picking up the tab at the Acme Oyster House in the Big Easy this December (these are good guys and this is a bet I don't mind losing).

However, I'm not dead yet. Call me a silly optimist or whatever you like, but pay darn close attention to this 7%/no vol game and its effect on dev-stage biotech stocks. If (if!) big pharma gets in gear in 2H-2005 and starts spending some of that $109 bln in repatriated cash on partnerships and acquisitions, it may provide exactly the kind of exogenous bullish boost to the sector the 7%/no vol crowd cannot handle (see the $2 bln for Vicuron (MICU) today and its effect on the NBI). Since the 7%/no vol crowd is short the equity (and probably selling the options, too), a big run in the sector will completely hose their carefully laid plans to limit volatility.

If their volatility control fails, their investors will immediately pull the plug. They'll have to cover those shorts and buy back those options.

And maybe, just maybe I'll get a free dinner out of it in December.
No positions in stocks mentioned.

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