Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
The Food and Drug Administration is expected to render a decision on Arena Pharmaceuticals' (Nasdaq: ARNA ) obesity drug lorcaserin by June 27. Except if it doesn't.
At the FDA advisory committee meeting held earlier this month, the panel of outside experts endorsed the drug, but some doctors suggested that the agency should require additional monitoring of the potential for lorcaserin to cause heart valve problems. If the FDA follows the advice, there could be a need for a Risk Evaluation and Mitigation Strategy, or REMS, or a post-marketing trial, both of which would require additional paperwork from Arena and could trigger a three-month extension.
That's what happened to VIVUS' (Nasdaq: VVUS ) obesity drug Qnexa after the company modified its REMS, pushing back a decision. In fact, a delay is fairly common for drugs that get a six-month review cycle, which doesn't give the agency much wiggle room to complete its review. Decisions on Regeneron Pharmaceuticals' (Nasdaq: REGN ) Eylea, Human Genome Sciences' (Nasdaq: HGSI ) Benlysta, and Bristol-Myers Squibb's (NYSE: BMY ) Yervoy were all delayed during their six-month review cycles.
Investors can bet on the potential for a delay using options to create a calendar spread. This morning you could buy a $7 call that expires on Oct. 19, after a potential three-month delay, for $1.79. The call allows you to buy shares at $7 per share no matter what the underlying share costs. To help pay for that call, we can sell the $7 call that expires in July, after the current PDUFA date, but before a decision if there's a three-month extension. Selling the call brings in $1.06 for a net cost of $0.73.
First, the bad news
That $0.73 -- sold in contracts that control 100 shares, so $73 per contract -- is the most investors could lose because the two calls are at the same strike price and cancel each other out.
If an approval happens before July 20, shares would likely go zooming past $7. The value of the October call would go up, but so would the July one you're short. And because the binary even has already occurred, the difference between the price of the two calls will shrink.
If shares sink after a rejection, it'll cost less to buy back the short July call, but the value of the October call will plummet as well.
But there's big potential here
If the two calls cancel each other out, how does an investor make any money? By eroding the value of the sold call while keeping the value of the October call high enough to make a profit. If there's a delay in the decision, that's exactly what should happen. The price of the July call is so high because investors are betting that the drug will go up after the decision. No decision, no premium pricing; the $7 calls that expire on June 15, for instance, sell for just $0.22 because investors expect that the decision won't happen by then.
Profit from the trade is made by selling the October call and either buying back the July call or letting it expire worthless. The potential profit from the trade has multiple variables, including whether the stock trades up or down on news of the delay and when the delay is announced, but if you use the values of today's calls as an indication, buying back the July call could cost around $0.22, the current cost of the June call. And with the October calls still able to take advantage of the binary event, they should retain most of their value. Figure a potential profit around $1.50 or basically double the initial cost, which isn't too shabby considering you don't even have to hold over the binary event.
A less risky alternative
If you're confident in an approval but think there's a good chance of a delay, a covered call can be a good way to play Arena in the short term. Rather than buying the long-term call, investors can buy shares and, as in the calendar spread above, sell the July call.
A covered call is less risky because you'll still make money if the approval happens before the call expires. Buying the shares and selling the call would result in a cost basis of $5.12, and assuming shares went above $7 per share on an approval, you'd book a nice 37% profit.
If a rejection happens, you'll own shares that are sure to decline, but the loss might not be as much as it would be for a calendar spread.
If the decision is delayed, the call could expire worthless, assuming investors don't read too much into the delay and send the stock up substantially, otherwise you're left with that 37% profit. After the call expires, you could sell the shares or hold through the binary event. Either way, the credit from selling the call is yours to keep.
There's no doubling your money before the binary event in this scenario, but there's less potential to lose your entire investment.
Timing is everything
Doubling your money in about a month is appealing, but since the downside risk is close to losing it all, the calendar spread only makes sense if the chance of a delay is greater than 50%. I certainly won't be surprised if there's a delay, but I don't see enough of a margin of safety to make it worth the bet.
A covered call looks like a good alternative, but if you're confident in an approval, holding the shares outright will likely produce a better return on approval, and you don't have to guess whether there will be a delay or not.
The timing of one binary event -- the U.S. presidential election -- is virtually guaranteed. Find out which companies will profit if Obama or Romney are elected in the Fool's new free report, "These Stocks Could Skyrocket After the 2012 Presidential Election."