Biggest Loser and Biggest Winner

As promised, I will describe my biggest mistake of the year.  As a balance, I’ll include the biggest winner.

First the bad news.

This is bad mostly because it was supposed to be a safe place to “park” some bucks for a couple of months until I needed them later in the year.  Instead, it morphed into a position that will take a year or more to climb back into the black, if ever.

It was also a harsh reminder that the game is often rigged against the unwashed retail investors.

As some may recall, one of my favorite income plays is to keep a stable of low-priced developmental biotechs around, and write calls against them.  Occasionally they hit big, but while I wait, they can pay out option premia that annualize at 50% of the price paid, or even higher.

Human Genome Sciences (HGSI) was one of those a few years ago, when it traded in the single digits and didn’t have much corporate income to speak of.  If my fading memory serves, I got to write a couple of series of calls against it before they got a hit drug, and went flying up into the mid-20’s, and later mid-30’s.

But I was happy with my hefty option premiums and the $7.50 sale price the last options I wrote on it gave me.  HGSI had done its job, paying me several dollars of profit on a mid-single-digit investment.

As all of us do with our prior successes, I kept it on my watch lists.

Fast forward to last summer.

The economic news really hurt, and the global political news only made it worse.  The market was weak, and I knew I’d need cash for the last few months of the year for large annual bills (insurance, taxes, etc.), so I liquidated about half of one account.

A few days later, that cash was sitting in the account doing nothing.

Meanwhile, HGSI was scraping along the bottom of its past year or eighteen months’ trading range, which my number-watcher reptile brain told me was roughly from $20 to $35.  So I took the plunge, and bought a fair-sized chunk (half the cash I had raised) for around $21.50 a share, and I immediately wrote $22 calls against the position with six weeks left in them.  The options were over $2 a share, net, so I was happily thinking that even an ordinary dead cat bounce would make the option buyers call the stock away from me before expiration with the stock recovering back up to $25 or more.

It didn’t work out that way.

In fact, the stock kept going south, though it stabilized around $18 a share a couple of weeks after I started the position.  I added some in another account, and bought back the options in the first account.

At that point, it turned into a daily disaster, or at least that’s how it felt.

With plateaus along the way that looked like they might be bottoms, that stock went to $14, then to $12, then $10, then $9, $8 and $7.

It was near the end of that dispiriting collapse that I read a headline about one of the very few stock manipulation prosecutions these past few years.

Wouldn’t you know it?  A hedge fund manager was being slapped with a hefty fine for selling HGSI based on inside information and the medical trial consultant who tipped off the hedgie was facing jail time.

What were the odds of that?

I’m not talking about the odds of some sleazebag making a profit off suckering small investors into buying stock they know will be going down.  That happens every day.  I mean, what were the odds of someone actually getting caught?

The dirty deed was back in 2008, but when I read the news in November this year, I said to myself:

“Self, that one is worse than most if somebody got caught.  Chances are there are others who didn’t get caught, like the proverbial cockroach you see versus the ones you don’t.”

Since I hadn’t really followed HGSI when I didn’t own it, it didn’t take long to find out that the manipulation scheme was old news, as this story from last April shows.

Besides, I’m a stubborn one, and the reviews of the science behind HGSI’s Lupus treatment and new class of drugs makes it interesting, just as it was before GSK (Glaxo Smith Kline) teamed up with them to carry on the research and patient marketing for Benlysta.  I like the fact that they call it a “new class of drugs” and that it seems to help one of those weird whole-body auto-immune diseases that humanity suffers more and more commonly as we live longer and fill our personal environment with more chemical irritants.

Bottom line, I found other things to sell to pay the bills, and I keep toying with the idea of averaging my cost basis down.  Long time equity investors will tell you that is the surest way to make a loss bigger, so I haven’t done it.

So there you have it.  Confession number 1, my biggest mistake of the year.

On the other side of the balance sheet is my biggest winner (so far).

Also in the developmental drug Arena (pun intended), ARNA caught my eye when a message board colleague picked it in a stock picking contest a couple years ago.  As big as the first new treatment for Lupus in a half century might be, the Holy Grail of pharmaceuticals has to be a pill you can take that makes you lose weight.

Arena Pharmaceuticals is one of a handful of small biotechs chasing that drug world unicorn.  They came close when they passed the first round of patient tests with good safety, but efficacy that was statistically barely there.

Then came the kind of setback that is all too common among these companies.  One member of the FDA review committee got a ton of airtime in the hearing as he pounded on the elevated incidence of cardiac problems in the test rats that took many multiples of the indicated dose.  He wasn’t a cardiologist, but the panel was convinced to take the safe way out and ask for more tests.

The stock collapsed from the mid-7’s to settle in around $1.50 a share.  Even though I owned some in the 5’s, 6’s and even 7’s, I had collected a couple of dollars in call premiums for each of those shares.  Even so, once the stock penetrated $3 a share on the slide downward, I was underwater.

Then a funny thing started to happen.

For the past few months, somebody was out there buying 2013 LEAP calls struck at $4, $5. $7.50 and even $10 a share.  And they weren’t fooling around.  Today, there are over 26,000 contracts (2.6 million shares’ worth) open in that Jan 2013 series at those strikes, and my recollection is that at least three quarters of them were bought after the collapse to the $1.50 a share level.  Somebody was either insane, knew something, or was playing in the options to hide their action.

I’m a big believer in Occam’s Razor, the logical premise that the least complicated explanation is the most likely to be true.

Insane might be easy to accept, but most insane investors can’t commit more than a million dollars to their fantasy.  Knowing something and buying call options is one of the few ways people get caught for insider trading, so the second option seems unlikely, too.  Besides, for only a buck and half a share, why spend a million dollars buying $4 and $5 calls at a cost of half a buck?  So I chose the third explanation — that somebody was building a large position without having to disclose it.

I was happy to build my position over the past six or eight months at a net cost under a buck a share, and would be equally happy to have whoever was buying eventually take them off my hands at $4 or $5 a share.

Last week Arena spoke at the Piper Jaffray Health Care Conference and the Piper analyst responded to the encouraging presentation by raising the “neutral” rating to “overweight” and put out a one-year price target of $3 a share.

The stock responded nicely, moving from below $1.40 two weeks ago to over $1.90 a share today.  The options I sold for around 50 cents each went up to 63 cents.  That’s still sky-high for a $4 call with just 13 months left in it — in fact every out of the money option in this series features a very steamy implied vol well north of 100% per annum.

Still, I’ll take any week when my short calls lose me 13 cents and my long stock gains 50 cents.  It’s especially exciting to me when those calls are still seriously out of the money, since the stock has to more than double from here to make any of those options worth anything at expiration.

The good news is that the gains in ARNA are more than twice the losses in HGSI since this year began.  The better news is that if HGSI goes to zero, and if ARNA goes up to Piper’s target, I’ll be way, way ahead.

Now here’s the part that some option writers hate:  I sincerely hope the stock goes to $10 or $15 a share and the people who bought those options from me make a fortune.  I won’t shed a tear over the money I didn’t make by selling the stock for a bit more than $4 a share on average.

A year’s living expenses in profits from one stock does that for me.


PS Just in case it isn’t obvious, this stuff can be dangerous, and the ideas presented here are NOT investment advice.


2 Responses to Biggest Loser and Biggest Winner

  1. Marc says:

    My NAV has made a very nice move upward in the last 2 weeks. Problem is 3 posits that I sold near the money calls against and they have gone up every day for 2 weeks. I have a large gain that will transfer to a new owner on 12/17 and my NAV will drop considerably.

  2. hhill51 says:

    The lesson from HGSI and ARNA is to always be happy when you’ve sold call options that get exercised. It’s a corollary to the famous theorem that says you’ll never go broke taking a profit.

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