As I mentioned about a month ago, Arena Pharmaceuticals (symbol ARNA) has almost cleared a key FDA hurdle to launch its anti-obesity treatment. That caused a huge volatility premium to come into its options, and that premium has only gotten more extreme as the FDA’s decision day approaches.
Today I added to my position, in an interesting no-cash way. The September $6 puts and calls are trading to around 350% implied vol (!!!) After the jump, I’ll go through the numbers.
Here’s how the numbers work for a 10-contract position:
I sold 10 September $6 calls. They have 14 days left in them, and only 9 trading days. Net proceeds: $2.33 per share (currently quoted $2.25 bid, $2.30 asked).
I sold 10 September $6 puts. Also just 9 trading days left. Net proceeds: $1.53 per share (currently $1.55 bid, $1.60 offer).
So, I was short a $6 straddle, with the stock trading at $6.75. With the calls being in the money, their delta (share equivalent) was (minus) 0.704, while the puts made me net long a delta of about 0.288. Since the stock is going to close either above, at, or below $6 two weeks from today, you add the two positions and multiply by 1,000 shares to realize today’s net delta. That’s negative 416 shares.
By selling 10 of those straddles, I generated $3,860 in cash. That’s nearly $500 more than it cost me to buy 500 shares for $6.75 each.
By buying 500 shares, I shift my net position from being short 416 shares to being long 84 shares.
So what’s the profit and loss profile look like two weeks from now?
If the stock closes at exactly $6, both the calls and the puts expire worthless, and I keep the $3,860. I would still own the 500 shares I bought for $6.75 (net cost $3,380), so I own 500 shares free and clear, and $480 in profit. That’s the best case.
If the stock closes at $8, I’ll still be obligated to sell 1,000 shares for $6, so I’ll get $5,980, deliver my 500 shares I bought for $6.75, and be short 500 shares. I’ll have lost $390 on the shares I owned, and be underwater by just over $1,000 on the other 500 shares. But I’ll still have the $3,860 in options premia to cover the losses.
I don’t lose money, in other words, unless the stock closes above $10.45 or so.
On the bear side, if the stock closes at $4, I’ll be forced to buy another 1,000 shares for $6 apiece, and I’ll immediately be underwater by $2,000 on those shares. That will leave me net long 1,500 shares at a cost of $6,020 + $3,380 – $3,860, or $5,540. That works out to $3,69 per share.
So that’s it…. I make money between $3.69 and $10.45 on a stock that’s trading for $6.75 today. I have to watch it through the next 9 trading days to see what happens.
I don’t know you or your circumstances, so this absolutely cannot be advice.
If this confuses you, that’s a clear indication that you shouldn’t be doing trades like this. As always, my situation is substantially different from yours, and high-risk plays like this one are only for a few of us to get involved in.
A much safer play that’s even allowed for IRA accounts is to buy the stock for $6.75 and sell the in-the-money $6 calls for $2.25. As long as the stock is above $6 on September 18th, you make $1.50 on a $4.50 investment (not counting commissions). You lose money if the stock drops below $4.50 from its current level of $6.75. Not bad for two weeks.