Amazing Vol Play

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.

hh

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7 Responses to Amazing Vol Play

  1. George says:

    Always love these ideas and examples, Howard.

  2. Jolly says:

    Interesting find. The FDA panel meets on September 16th, right before
    September expiry.

    Back in July, Vivus (VVUS) had a violent move in price as its drug Qnexa, got a thumbs down from the FDA panel.

    Still, I find the volatility play intriguing enough that I’m going in with short Sept puts at $3 for $0.35. If it drops to $2.65, I lose money and have to buy the common. Even then, there’s a remote chance of recovery when the FDA decides on final approval in October.

    Otherwise, I’ll pocket the $0.35.

    Orexigen (OREX) with a competing obesity drug and an upcoming FDA review date in late October, is another one to watch.

    • hhill51 says:

      Thanks… I’ll look at them next week.
      I have been speculating (and that’s what it is) on pre-approval drugs for years now, and I think the best strategy is not to try to pick the home run. Even a winner like DNDN can be crushed by corruption, or bad luck, especially if the hedgies have taken a dislike to the company.
      \\
      Still, for all their billions, it seems like the majors aren’t doing much early stage research, but just figure they can buy or partner with any small company that gets something promising because of the $100 million plus it takes to conduct trials.
      \\
      That makes the small companies hugely volatile as news and PR on both sides of the issue swirl about. If I own a half dozen or more of them for under $5 each, and get 20 to 40 cents a share on a regular basis by writing calls, I can basically turn them into hefty income producers while I wait.
      \\
      The winners blow out, and get called away for a nice profit, but even then they sometimes qualify for buy-write strategies with short term (under 3 months) returns in the 15% to 30% neighborhood if they get called away.
      \\
      VVUS and OREX will now go on the watch list.
      thanks again,
      hh

  3. bacchus614 says:

    I’m fairly new to options and find your postings very helpful: the more I read, the more I understand. I sold Sep 6 and 8 covered calls when you initially mentioned them, and sold some more 6s today using your second example. One of these days I’ll fully understand straddles and other approaches. Patience, grasshopper.

  4. Jesse Livermore says:

    Not sure I like this play. If the drug gets rejected/sent back for more data, the stock goes way below 4, like to 1. (ARNA has a few other drugs in the pipeline, but they’re all at Phase I.) If it gets approved, who knows? A double to 13+ would not be out of the question. What scenario do you see where ARNA lands in the middle and you win on your straddle?

    • hhill51 says:

      I think the company becomes an attractive takeover candidate for the big guys below about $4 or $5 a share (half a billion dollars), because the efficacy was not the issue, just safety. That means the science is worth owning when the result is going to be a blockbuster, even if the result is that they send them back for another round of tests.
      I do see a real risk that the price could blow past my upside collar, but that’s why I own some shares outright in an IRA account, and why I plan to be at my desk that Wednesday and Thursday.
      I made good money on DNDN and ELN in the past, but with each I suffered some time with my position underwater. I also did alright with HGSI, one that really never looked back after it took its big jump upwards.
      I also own a couple of others in “under $5 with promise” category, so it’s really a strategy of owning a bunch of them, writing out of the money calls most of the time, and then playing the vol for bigger stakes when the opportunity arises.

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