A Super-Cheap Call Option

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When an investor buys a call option, it's a bet that the value of the underlying security will go up in the future. For instance, buying a $60 call option on Procter & Gamble (NYSE: PG  ) is a bet that P&G's stock price will close higher than that by the time the option expires. The investor puts up a little now to make a lot later.

Investors use call options to limit risks and supercharge rewards -- hit up the Motley Fool Pro guys to view this in action -- and companies like GlaxoSmithKline (NYSE: GSK  ) can do the same kind of thing. Let me explain.

Today the company announced it's partnering up with tiny Dynavax Technologies to develop up to four drugs for autoimmune and inflammatory diseases such as lupus, psoriasis, and rheumatoid arthritis.

Glaxo paid a measly $10 million dollars to tie up the four drugs. It'll owe more -- up to $200 million per drug -- if it decides to develop the drugs and they turn out to be successful, but Glaxo gets to wait and see if the drugs are able to achieve proof of concept before deciding to develop them further.

I really like Glaxo's system of using call options to gain access to the drugs. In this case, just like an option buyer, instead of paying more up front -- it probably could have just bought all of Dynavax for $50 million more -- Glaxo gains control of those drugs. But, it doesn't have to fund the development program and so doesn't run the risk of losing more money if the drugs turn out to be duds. Glaxo has similar deals with Alnylam Pharmaceuticals' (Nasdaq: ALNY  ) and Isis Pharmaceuticals' (Nasdaq: ISIS  ) joint venture Regulus Therapeutics, among others.

By not buying the company outright, Glaxo also keeps the fire under Dynavax. Sometimes small biotech companies are successful not because they're smarter than their pharmaceutical counterparts, but out of necessity. Employees know that the success or failure of their company depends on success in the lab. Incorporated into Glaxo, Dynavax would just become another division with a safety net underneath it.

The deal structure also allows Glaxo to make the decision farther down the line when it has a better look at how its pipeline is shaping up. In a similar situation, Glaxo turned down Exelixis' (Nasdaq: EXEL  ) thyroid cancer drug XL184, which Bristol-Myers Squibb (NYSE: BMY  ) licensed last week. Some -- including me and Exelixis CEO George Scangos in an interview done for our Rule Breakers newsletter -- speculated that the decision was based on the needs of Glaxo.

Glaxo's option drug deals -- with 16 different companies -- take time to develop, but I think they're a wise use of Glaxo's cash, and should pay off handsomely in the long term. While it will occasionally forfeit the upfront money, when it does pick a winner, the return could be fantastic. Go options!

GlaxoSmithKline is a Motley Fool Income Investor selection. To see how dividend-paying stocks can offer both secure income and the opportunity for growth, take a free look at this newsletter with a 30-day free trial.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Exelixis is a Rule Breakers pick and the Fool owns shares. The Fool also has a disclosure policy.

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