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Derivatives and Risk Management Options Trading Strategy in AstraZeneca

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Derivatives and Risk Management Options Trading Strategy in AstraZeneca
Executive Summary
The following analysis was conducted in response to a request by the investment management
department of the company to build a hypothetical options trading strategy with an investment
amount of 100,000 British Pounds (GBP) over a 35 day period starting from March 9 2020, in a
listed entity in the FTSE 100 index of the London Stock Exchange. Based on fundamental
analysis including the current market conditions and the impacts of the novel coronavirus
(COVID-19), I have decided to allocate the investment amount into an options trading strategy in
AstraZeneca (AZN), a biopharmaceutical company and leader in the Pharmaceuticals and
Biotechnology sector of the market.
Part A
Part A will display two analytical parts. The first is the fundamental analysis (quantitative and
qualitative) by discussing the current market sentiment, macroeconomic environment during the
35 day investment period, and other factors which lead to the choice of AstraZeneca of the FTSE
100. The second will be the technical analysis to show when to buy the stock.
Overview of AstraZeneca PLC
AstraZeneca PLC is a multinational bio-pharmaceutical company known for its innovative
discoveries, developments, manufacturing and sale of medicines and other biotechnology
products. Established in April 1999 as a result of a merger between the Swedish Astra AB and
British Zeneca Group PLC, AstraZeneca was formed to deliver innovative medicines to cure
serious global diseases such as cancer, respiratory, neuroscience and cardiovascular diseases;
amongst others (AstraZeneca, 2010). AstraZeneca is listed on the London Stock Exchange and is
one of the constituents of the FTSE 100 index in the sector of ‘Pharmaceuticals and
Biotechnology’ with a market capitalization of 115,870 with a trading volume of 983,982 as of
the 23rd of April 2020 (Bloomberg.com, 2020)
In order to properly decide on an options trading strategy, it is vital to conduct a fundamental
analysis on the financial aspect of AstraZeneca. Most of AZN revenue comes from product sales
which amounted to $23,565 million and collaboration revenue of $819 million (AstraZeneca,
2019). As shown below, the revenues of AZN increased in 2019 relative to 2018 and had a
higher PE ratio as well
Table 1. Financial Overview of AZN
Income Statement 31-Dec-18 31-Dec-19
Revenue ($ million) 22090.00 24384.00
PROFIT FOR THE PERIOD 2050.00 1227.00
Earnings per Share ($) 1.70 1.03
Dividend per Share 280.00¢ 280.00¢
2
Table 2. Ratios of AZN for 2018 and 2019
Ratios – based on IFRS 31-Dec-18 31-Dec-19
PE Ratio * 44.22 97.49
Price/Earnings-to-Growth (PEG )* -1.56 -2.47
Earnings per Share Growth -28.27% -39.41%
Dividend Cover * 0.61 0.37
Revenue Per Share 1743.49¢ 1874.25¢
Pre-Tax Profit per Share 166.22¢ 127.90¢
Operating Margin 15.33% 11.99%
Return on Capital Employed 10.53% 9.39%
Dividend Yield * 3.72% 2.79%
Net Asset Value per Share (exc. Intangibles) -1673.03¢ -1476.52¢
Net Gearing * 114.55% 92.81%
(Source: London Stock Exchange, 2020)
In addition to a healthy financial position, the management of the company is also stable. Filbeck
and Tompkins (2004) state that leaders with longer tenors perform better. This is clear in AZN as
the Chairman, CEO, and CFO as well as other top management maintained their positions in the
firm for the past years (AstraZeneca.com, 2020a).
During the 35 day trading period it is apparent that AZN put forth efforts to find a cure for the
COVID-19 virus which is reflects positively on the company’s share price. On April 8, 2020, it
joined forced with the government to develop an anti-body treatment against covid-19
(Astrazeneca, 2020b). Furthermore, its expertise and competitive edge in more deadly diseases
gives the company prospects as the company announced it is testing its cancer medicines to
control the response in some patients (Fourcade & Ring, 2020). On April 14, 2020, the
biopharmaceutical giant announced that it would have a trial in record time to test the immune
response of COVID-19 patients. The stock also climbed 7% on the 14th of April once it
announced testing the drug used for blood cancer for the severely ill COVID-19 patients
(Keown, 2020). Additionally, London stocks witnessed a rally in equities on the 17th of April as
the announcement of a potential cure to the COVID-19 virus motivated investors and led several
stocks to soar; AstraZeneca PLC climbed 2% (Kollmeyer, 2020). Other announcements which
affected the share price are found in Appendix A.
Global and Industry Related Analysis
In order to assess the market sentiment in which AstraZeneca’s segment operates in, we must
first highlight the overall macroenvironment. The first quarter of 2020 witnessed a rollercoaster
of events starting with the unprecedented Covid-19 virus and dramatic crash in oil prices which
3
slumped further mid-April. The unforeseen spread of Covid-19 and the domino effect of
economic and global changes sacked international markets at a high pace. Even though the
economic impacts of the coronavirus pandemic were not yet well-defined in March, the financial
market already took a stance with intense actions where on March 12, 2020, the FTSE, the main
index in the UK; dropped more than 10%, making it the worst since 1987 (O’Connell, 2020).
Sharif, Aloui & Yaroyaya (2020) depict that the combination of the oil crash and the COVID-19
pandemic introduce a possible long-term economic recession. Furthermore, Corbet, Hu, Lucey,
and Oxley (2020) found that entities would face negative hourly returns but with a noticeable
large hike in volatility and the volumes that are traded post announcement of the pandemic.
Seeing that the investment management department wishes to invest in the period between
March 9 2020 and April 28 2020, it is of utmost importance to center investment efforts in a
company operating in a resilient sector during the ongoing economic anxiety. Hence, the choice
of the pharmaceutical sector.
Pharmaceutical Industry
The pharmaceutical industry could be considered one of the best to seek refuge in as Covid-19
damages the economy because of its focus on delivering innovative products and positive sales
outlook (Alpert, 2020). Therefore, over the past year, it could be denoted that the industry has
been preforming on promising levels. The bullishness that was set forth by pharmaceutical giants
in finding a solution to the Covid-19 disease sent their stocks soaring and increased investor
sentiment towards them. AstraZeneca is one of the key pharmaceutical giants which immediately
responded to the Covid-19 pandemic with its innovative bio-technology (Keown, 2020).
The PE ratio of AZN for the month ended 31 March 2020 was 90.7 as opposed to the
Pharmaceutical and biotechnology sector PE ratio of 30. Likewise, for the PB ratio, AZN in
comparison to the industry was 9.6 to 7.5, respectively. It can also be viewed below that AZN is
performing better than its industry and the FTSE 100 in Figure 1.
Table 3 . Performance Ratios of AZN relative to the Industry
Ratios March 2020 Industry
Price to Earnings 90.7 30
Price to Book 9.6 7.5
Price to Cash Flow 39.1 17.9
Price to Sales 5 3.2
Dividend Yield % 3.9 3
4
Note: retrieved from Mactrends, 2020
Figure 1: Performance of AZN relative to the FTSE 100 index and its industry. (Source: London
Stock Exchange website)
Competitor Analysis
Several factors affect the pharmaceutical industry, especially a pandemic. The race to create a
vaccine to tackle the COVID-19 virus included major pharmaceutical companies such as Pfizer,
Moderna and Johnson & Johnson (Franck, 2020). The revelation of a vaccine is in return is
expected to change share prices. However, AstraZeneca is known for its innovative biotechnology focused on patients with major diseases; which are the patients who are highly
vulnerable to the ongoing virus. This differentiates it from competition and inevitably would lead
to concluding that AstraZeneca has promising prospects in terms of both short and long-term
investments. In the short-term, market sentiment and the desperation to find a cure for the virus
is ongoing which would push stock prices up. Having the innovative capacity and dynamic focus
on top of its contenders. Hence, this is why it is also important to conduct a competitor analysis
of AstraZenca’s competition.
Appendix B, C, and D depict the growth of AstraZeneca’s stock (AZN) against two other
pharmaceutical giants on the FTSE100: Hikma (HKM) and GlaxoSmithKline (GSK) on a 6
month, 1 year, and 5 year period respectively. It is shown that Hikma and AstraZeneca are close
competitors on a 6 month and 1 year period but AstraZeneca has been outperforming its rivals
over 5 years. Figure 2 below highlights the performance of AstraZeneca against competitors in
5
the industry. It shows that the company was performing better than its industry average in terms
of P/E and revenue gain.
Figure 2: AZN competitor performance analysis (retrieved from: Bloomberg Terminal)
Overall, it is apparent that the industry has performed well and AstaZeneca is performing well
relative to its rivals and will most likely continue to perform well over the next couple of months
based on these industry specific factors. This is because AstraZeneca adds a competitive
advantage whereby it opts to find a cure for the pandemic to the patients who are susceptible to
the disease.
In order to illustrate the strength of AstraZeneca, a SWOT Analysis has been computed below
Table 4. SWOT of AZN
Strengths
 Product innovation
 Satisfying returns and several revenue
streams
 Prominent distribution network
 Renowned brand name and portfolio
Weaknesses
 High number of failed trials thus high
costs incurred
Opportunities
 Its long-term expertise in chronic diseases
gives it a chance to innovate and develop
drugs that would help the patients that are
most vulnerable to COVID-19
 Growth prospects in emerging markets
Threats
 Very intense competition in the time of
COVID-19
 High costs associated with developing
Note: self-constructed SWOT based on above arguments.
Technical Analysis
In order to decide when to place the trading strategy, a technical analysis is conducted. Since this
is an options trading strategy, the Exponential Moving Average (EMA) was chosen as it gives a
higher weight to the newer data; giving it a higher sensitivity to unexpected price changes and
6
reacts quicker making it ideal for the volatile and short-term nature of options (Ng, n.d.). When
the price of the stock is above the EMA, a bullish strategy should be taken (Ng, n.d.). Figure 3
shows how the stock price of AZN reached the 20 day EMA over the previous period in
February. Also, Beta is below 1, assuming that the stock is less volatile than the market
(Economic Times, 2020). Appendix E shows the beta of AZN at 0.783 indicating when the
market changes, AZN moves 78% with it. The price drop could be from a sudden reaction in the
international markets on sentiment about Covid-19. However, a bullish trading strategy is still
recommended as the stock price redeemed itself and future outlook of the stock is promising in
the era of a pandemic and AZN being a pharmaceutical innovator in a highly a sector investors
eye during health crises.
Figure 3: AZN stock and exponential moving average (tradingview.com)
Option Trading Strategy
Options can leverage returns as opposed to a simple stock trade. Traders use options to benefit
from future price movements. Given the anticipation that this company will do well, it is
speculated that the stock will be higher. After assessing all the factors in the current sensitive
market, volatility of AZN and technical analysis, the options trading strategy chosen is a ‘long
call’ with Vanilla, American options. This is because AZN is a pharmaceutical innovator
operating during desperate economic times and investors hope to find a cure for the
pandemic.The strategy is to buy into a long call on March 9, 2020 where AZN share price on that
day was GBX 7,003 (70.03 GBP). Referring to the options screen in Appendix F, it is
recommended to buy into the call option expiring April 17, 2020. Given the GBP 100,000 limit,
the department can by up to 1,428 options.
7
Appendix G illustrates when the strategy will be in the money, precisely when the share price is
at 74. Assuming multiple scenarios as shown in Appendix H, it is clear that by choosing a long
call, there will be unlimited profit should the expected price of the stock rise and the loss will be
limited to the premium paid.
Part B
The profit made on the call is shown in Appendix H and explained further in part C. Assuming
that the department was as bullish as this report, and exercised the contract at expiry, the
annualized return for the holding period of 29 working days will be at 3.52% as computed
below:
Annualized return= ((initial investment + profit) / initial investment) ^ (365/days) – 1 (Tholen,
2016)
=(111,481.12/100,000)^(365/29)-1 = 3.52%
The effects if the coronavirus is usually compared to the 2008 financial crisis and the unexpected
call of the Saudi Arabian authorities to offer oil at a discount sent a shock wave through the
global stock markets (Sharif et.al, 2020). Therefore, there are several risks which must be
highlighted. Whilst the pandemic persists, investors should be cautious of how to deal with a
volatile stock market and the systematic risk the epidemic brings. (Sharif et.al, 2020). Systematic
or market risk is eminent as a result of covid-19. This would definitely affect any trading strategy
investors opt to choose. This is because the market prices will be sensitive and will react to the
market sentiment, leading to stock prices changing quickly. Another risk facing the department is
counterparty risk where the other party involved in the option (the seller in our case) does not
sell when the department wants to exercise its right (Thompson, 2009). Interest rate risk arises
when the asset value declines and leads to unprecedented changes in interest rates (Corporate
Finance Institute, n.d.).
Part C
Since a long call option was chosen, the profit is basically unlimited but the maximum loss
would be the premium which was paid. However, if the option was not exercised at expiration
(equal or lower than the stock price), it would expire worthless and the total price paid for the
call will be lost. On the expiry date of the call option chosen, the price of AZN spiked to GBX
8,120 (GBP 81.20) (London Stock Exchange), as speculated by the bullish view taken in the
onset of the report. Therefore, the actual profit realized is GBP 8.04 per stock; a total profit of
GBP 11,481.12 (6.54 x 1,428 call options).
Long call option to puts less money at risk should AZN stock goes up in value, the department
benefits on the increase on the value of the call. The reason why the strategy achieved its profits
8
is a mirroring of the fundamental analysis undertaken and especially the weighing out of the
pandemic crisis and public sentiment to invest in pharmaceuticals in desperate times. The bullish
view was taken regardless of the fluctuation of the price and proved true. Appendix I shows the
increase in the stock price supporting the bullish speculative view and concreting the call
strategy chosen. This investment is beneficial for the portfolio of the requesting department.

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