A:

The covered call and long straddle options strategies enable investors to capitalize on the unique characteristics of the drugs sector to make money. The covered call works best with the more stable pharmaceuticals segment of the drugs sector, while the long straddle takes advantage of the inherent volatility in the newer biotechnology sector.

Volatility largely determines which option strategy is best for investing in a particular market sector. Certain strategies reward wild market swings in one direction or the other, while others allow investors to profit from flat movement. The two segments of the drugs sector differ in volatility. The pharmaceuticals segment, composed of companies that sell chemical-based drugs, is larger, more seasoned and more familiar to investors, making it the less volatile of the two segments. The biotechnology segment, comprising businesses that harness new technology to create and sell drugs from living cells, offers investors greater profit potential but comes with higher risk, hence more volatility.

The covered call generates profits even when a security does not move much at all, making it a popular strategy for investing in pharmaceuticals. With this strategy, the investor sells a call option on a security he also owns. The buyer pays a premium for the call option, which gives him the option, but not the obligation, to buy the security at a prearranged price, known as the strike price, by a future date, known as the expiration date. A call option becomes profitable to the buyer when the price increases because he can then buy shares at a discount and turn around and sell them for a profit.

The seller, in this case the investor employing the covered call strategy, profits from selling the call option if the security price remains flat or declines. In these scenarios, the buyer almost always lets the option expire, and the investor keeps the premium as profit. If the price rises and the buyer exercises the call, the seller must sell him the shares at the strike price, which is lower than the market price. The seller is covered, however, because he owns the shares, so he does not have to buy them out of pocket and then immediately sell them at a loss.

For investing in the biotechnology segment, the long straddle provides a way to profit on its frequent price swings. The investor purchases a call option and put option on the same security, with the same strike price and expiration date. A put option is like a call option except the buyer has the option to sell, rather than purchase, shares at the strike price by the expiration date. If the security increases in price, the investor exercises the call, purchases shares at a discount and then sells them for a profit. If it decreases, he exercises the put and sells shares at a premium. He loses the premium he paid for the option he does not exercise, but a sufficiently large price movement, which is likely with a volatile segment such as biotechnology, generates a profit on the exercised option that more than compensates for the premium loss.

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