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