Update on ARNA Trade

Arena pharmaceuticals has been quite the roller-coaster lately, with daily trading ranges as high as 10% or more of its price.  The near-dated options are now trading with implied vols between 250% and 300%.

As if to underline the danger of playing a developmental drug company awaiting approval, a prominent hedge fund manager was quoted this week saying ARNA was an excellent short.  While I’m sure he was talking his book and hoping to see some others jump in and add to the selling pressure, it does help us see how this game is played.  More on that after the jump.

Still, I added in a small way to my exposure yesterday when I saw that the May call options have huge premiums.

Specifically, I bought the stock and sold May $2.50 calls.  Here’s my thinking:

The potential positive (or negative) event, ruling on approval by the FDA or by the European authorities, is almost certain not to happen before the third Friday in May.  The best estimate I’ve seen for FDA action is the end of June, and I’ve got to believe that the European drug approval process, just recently initiated, will take longer than that, probably by months.

So when I bought the stock for $2.80 and sold the options for a buck, I was thinking that the price movement between now and option expiration will be determined by the eternal war between bulls and bears, shorts and longs, but not by actionable information about the company’s prospects.

To pick a broad band, I expect that in May, the stock will trade between $2.50 and $3.50 a share, so most likely my new shares will be called away.  If they are, I’ll net just under 70 cents a share in profit from a net investment just over $1.80.  That’s an extraordinary return in six weeks.

If the stock closes below $2.50, the potential will still exist for their weight-loss drug to be approved by the FDA or the Eurozone, or both.  That means the longer dated, out-of-the money calls (say, for example the $4 January calls I have outstanding on most of my position) will still command prices above a buck.  If I turn around and sell those after the May series expires, I’ll lower my cost basis well below a dollar a share.  That’s lower than the price the stock went to after the initial FDA rejection, a moment in time when it became obvious that the company was going to lose money for the next couple of years and be forced to raise additional capital to keep going.  Put in market player terms, that was exactly the situation the short sellers love, where they can slam a stock with as much shorting as they can borrow, and know with near certainty that the company will issue new shares at a lower price they can buy to cover their shorts.

Anyway, that’s how I’m playing this situation, even with hedge fund managers saying the company is a great short.

Now, as promised, I’m going to say something that may not be obvious about traders sharing their wisdom about individual stocks.  Years in the market makes me a skeptic, so I always assume that anyone talking about a stock price going up or down is “talking their book” and hoping the public joins them in the trade.  There is one crucial difference that we should always consider:

Bulls need other investors knowing the trade idea and joining them, but bears don’t.

What may not be obvious is that there is a fundamental difference between being long a stock or short it.  That difference is that a trader hoping to profit from a long position always needs other investors to become interested in buying the stock.  Without other (new) buyers, the trader on the long side can’t make their profit.  In fact, to maximize their profit, they need as many buyers as possible.

When selling short, however, the key to maximizing profit is to have as few people as possible joining you on the short side of the trade. 

Here’s why:

Every stock has a limited amount of stock available to borrow and sell short.  If too many people want to sell the stock short, the stock becomes hard to borrow, and the seller has to pay a premium interest rate to the owner of the stock to borrow it.  That premium can and does run as high as 50% per year for widely hated stocks.

If a short seller has limited capital and only wants a very short term profit, it can actually increase their return by having other short sellers join them in the trade and accelerate downward price movement, but if the short seller truly has discovered a company whose price is heading to zero, they can actually maximize their profit by periodically taking profits (closing out some or all of their short) and re-deploying the capital in a new, larger position.

A simple example with a few numbers will make this clear.  I’ll use the leverage we poor dumb retail investors can get instead of the much higher leverage hedge fund guys get from their prime brokers, since the mechanics are the same.

Let’s say I figured out that a company with a million shares selling for $20 a share is really worthless, and likely to go out of business.  If I sold 10,000 shares short through my brokerage firm, I’d get $200,000 in proceeds, which my brokerage would hold onto against the position.  In addition, my brokerage would charge me for another $100,000 of margin capacity to give themselves a cushion in case my trade went against me.

But say I’m right, and the company performs badly and begins to disappoint the holders of the stock.  Let’s say, in this example, the stock drops to $15 a share.  At that point, I can close the position for a $50,000 profit.  Now I’ve got an additional $100K in margin capacity, thanks to the $50K in cash profit I made.  Let’s say I’m still really sure the company is going away, so I use my $200K in margin capacity to short $400K worth of stock.  At $15 a share, my new short position can be as large as $26,666 shares.  For ease of computation, let’s say I short 25,000 shares on round two.

I rinse and repeat several times, renewing the position at $10 a share, $8, $6, and $4, and reinvesting with profits each time.  Even at retail leverage levels, my total short position grows faster than exponentially.  (For some real fun, check out the topic of my senior oral exam back in college, the Gamma Function — it’s way cool.)

To show the increase in position size and profit, here are the results from my little example:

At $10 a share, I renew the position, taking $5 per share profits on 25K shares, or $125K in profit.  Now, with my original $100K in margin capacity, the additional $100K from round one, and the new $250K in additional margin, I have margin of $450K available, so I can sell $900K worth of stock.  At $10 a share, in Round Three I can short 90,000 shares.

When the stock hits $8 a share, I begin Round Four, taking $180,000 in new profits ($360K in additional margin capacity), so I have $810K in margin available, which lets me sell $1.62 million of $8 stock, or 202,500 shares.  Let’s make it 200K shares to make it simple.

At $6 a share, I have another $400,000 in profits, which increases my selling power to $1,620,000 +$800,000 or $2.42 million of stock, which by now amounts to 403,333 shares.  Let’s make it 400K shares to keep the numbers simple.

At $4 a share, the profits are an additional $800,000, giving total margin capacity of $2.42 million plus another $1.6 million.  At that point, with the stock at $4, I have more than enough capital to short every share in existence.

All without ever telling anyone about the idea.

So I am doubly skeptical about hedge fund managers sharing their wonderful short ideas.  They really don’t need anyone else in the trade with them if they are correct in their analysis.  In fact, others entering the trade makes it more expensive for them, and limits their profits.

Unless, of course, the stock goes up after they put on the position, and they need some help to limit their losses.

Just sayin’.

hh

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13 Responses to Update on ARNA Trade

  1. Marc says:

    BOL to you. I’m just starting to figure out puts. I’ve got a ways to go for this.

    • hhill51 says:

      Hey, Marc…
      Good to hear from you. I think what escapes when I talk about options is the simple fact that covered calls are the most conservative way to use them (even more conservative than simply buying stock). In fact, covered calls are the ONLY option strategy that will automatically be approved for IRA accounts. My trade yesterday, buying the stock and selling in-the-money $2.50 calls, is a high probability, high return play, since most likely the stock will be called away with a 37% profit in less than a tenth of a year (now 35 days). To lose money at all, the stock has to close below $2.50 when the options expire in May, and then keep going down.
      hh

  2. James Reece says:

    Thanks for the mental challenge. macdr

  3. Sam says:

    Hi,
    I would like to know your opinion on selling May 2.5 call and May 2 put.
    I will collect $1.25 premium and will start losing the money only if the stock will below $ .75.

    Thanks,
    Sam

    • hhill51 says:

      hey, sam…

      I think the main risk of this trade is to the upside. If the stock is above $3.75 at expiration, you also lose. Since the advisory committee meets May 10th (not the actual FDA approval hearing, which is end of June), a positive reco could send the stock back into the $6+ neighborhood. If the stock were at $6.25, then you would lose nearly twice the potential gain of selling this straddle.

      Even though the losses come at a higher (low) price with the covered call trade, I think that is safer, because owning the stock gives you the ability to sell more options after the May series expires. It’s all a crap shoot right now, and it’s clear that the shorts are heavily involved here. I even heard from a friend that ARNA was short-sale restricted yesterday, presumably by his brokerage firm because they couldn’t locate any shares to borrow and sell short (legally). Unfortunately, some scumbags “rent” the options market-maker exemption from naked short selling restrictions, giving them unlimited firepower on the sell side. If they can also shake loose long shares by pounding the stock, they win, even if they’re wrong on the fundamentals.

      It’s as if the famous line from Casablanca was changed to say “I’m shocked. Shocked, I tell you, that there is cheating going on in this establishment!”

    • hhill51 says:

      Hey, Sam….

      Just took another look at the May options, and I think your idea has more merit if you look at selling the $2/$3 put/call strangle. You get basically the same proceeds (a nickel less) but you don’t start losing money on the upside until the stock exceeds $4.20 a share. Seems much safer for almost identical downside risk.

  4. Hello Howard,
    I took the liberty to quote your thought-provoking post:
    http://seekingalpha.com/article/514291-dendreon-is-not-a-great-short
    Regards,
    Giancarlo

    • hhill51 says:

      Since I also survived both rounds of the DNDN story (loading up in 2009 after having huge losses in 2007), I’m actually looking at DNDN as a model for what might happen with ARNA.

  5. CC Brown says:

    Hi Howard: I believe the adcom is a safe play and have acted accordingly with May calls. Given VVUS 3 month delay and the increased attention the media appears to be focusing on obesity and its costs to society as a whole, do you have any feel for initial market reaction to a very positive adcom vote like VVUS had in Feb.

    After initial run up, what do the short/hedge folks do to the stock? How will they manipulate it? What should us small retail investors be on the look out for?

    • hhill51 says:

      To me, the action the past week seems to be a setup to run the stock price down (complete with CNBC interview, scary headlines on Street.com, etc.) and then to switch long for a runup. Then the shorts will come again after the advisory committee (assuming positive reco), and they re-set the shorts for another round, with the price high in the single digits. That would echo how they played the Dendreon game and a few others I’ve seen over the years. It’s hard for us on the outside to guess what they’re up to. History may not exactly repeat, but it does rhyme.

      hh

      • CC Brown says:

        They were helped out by Greenfield’s 20+ million warrants that they have been dumping over the last couple weeks. Wouldn’t they want to run this thing up into the $12-$14 range with cheap options, sell them and then use that money to buy puts, etc and short the stock for maximum effect?

        I’m just trying to gauge how High the stock could run up before they begin their tricks? I know no one has a crystal ball but since I’m new to this whole game and have only read about the DNDN and what they did, from $5 to $20 after first adcom, I don’t want to be foolish because I will be in this for a long long time as the science is sound.

        Thanks for any inisghts.

  6. I made the exact same play as you did at around the same time, then after checking the math I sold the 3.50 options for a few less cents but still gave myself a cushion in addition to a little upside if stock does happen to go up.

    I dont know if you know this but they are meeting with the fda on may tenth for a committee recommendation and the fda will probably heed the recomendation. I was also hoping to get by on no news until may and get out with a massive short term return but now we are stuck in a coin flip.

    your theory on shorts is a sound one but this stock is already at the bottom the time for them to crow is now, I hope they get killed but once your bet is in there is nothing to do but bash the crap out of the poor hapless stock. luckily for us fear mongering means nothing compared to what the fda is going to say. hopefully it is hopefull. :)

    good article and good luck my friend.

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