- * For biotech, downside is limit but upside is hard to predict as short cover. so should do uneven butterfly instead of even butterfly.
- * For biotech, FDA can be early
- some small bio tech can fail the FDA but not go to zero, so a ratio spread for put is a very good idea.
--------------------------------DNDN Setup by Fahad-----------------------------------------------
EG 1) DNDN
Dendreon (DNDN) will face the final decision by FDA on or before May 1 for its prostate cancer treatment vaccine called Provenge. As recently as March 3, the management announced updated results of its 512-patient trial which showed improved three-year survival of patients with advanced prostate cancer by 40% compared with a placebo.
One in every six men in the United States suffer from prostate cancer. There is almost unanimous belief among analysts that Dendreon will have no problem getting FDA approval. If approved, sales are expected to jump to as high as $2.5 billion by 2011 (I have seen estimates of $1 billion to $5 billion with many analysts around $2.5 billion).
I already have a trade on since March 22: DNDN Call Ratio Spread. For now, I plan to hold the trade through FDA decision. But if anything changes, I will communicate through housekeeping note.
Currently, May at-the-money straddle is pricing $13 or 32% move on FDA decision. I believe if FDA comes out with outright denial, the straddle is significantly underpricing the move as I can see the stock collapsing to single digits. With an outright approval, I see the company commanding minimum market cap of 3x potential sales or $7.5 billion which puts a near term price target of $55-60 range. Stock currently trading around ~$40.00.
I will be watching closely option activity periodically everyday to check the pulse. Some readers have asked me to provide other ways to trade DNDN. Here are a few setups. Note that these setups are suggested with idea in mind "what if" you're wrong. I will not suggest to outright buy calls or puts. Regardless of your sentiment and trade set up you choose from below, the first priority is to minimize your risk in case you're wrong.
1. If you believe the treatment will get approved and the straddle is under-priced, then I suggest the following bull call ratio spread:
- Sell to open 1x May $30 calls
- Buy to open 2x May $40 calls
The natural asking price on whole structure is exactly $0.00 (mark is $0.20 credit). The setup will require a move above $50 to produce profits. Gains are unlimited. On a bad news if stock collapses below $30, there is no gain or loss.
2. If you believe the treatment will be disapproved, then you sure also believe that straddle is way under-pricing the potential move to the downside given the stock was trading at $7 a year ago. In that case, I suggest the following bear ratio spread:
- Sell to open 1x May $50 puts
- Buy to open 1.5x May $43 puts
The whole structure can be done for $0.25 net credit. The structure will require a move below $29.25 to turn a profit. But if you're wrong and the news is good and the stock rips higher above $49.75, there is nothing to lose as both legs expire worthless and you just keep the credit.
3. If you believe the treatment will get approved but the straddle is over-pricing the move to the upside, then I suggest the following diagonal bear call spread:
- Buy to open Jan'11 $55 calls
- Sell to open May $50 calls
The whole structure can be done for $3.75 net debit. Notice I am using LEAPS Jan'11 for the long leg because of IV skew (Jan'11 at 85 vs. 160 in May). The break even range in this trade is very large. The trade remains profitable anywhere between $36 and $69. Therefore, if you're wrong and it turns out that the straddle was under-pricing the move, the trade should still produce a profit as break even on the upside is $69. I expect very minor decline in Jan'11 implied volatility, if any.
4. If you believe there will be no outcome by FDA and the decision will be delayed (it has happened with DNDN at least twice before in last several years), then there is a chance that the stock will get hammered but not nearly as much as it would if there was an outright denial. In other words, you're negative but believe the straddle is over-pricing the move to the downside. In this case, I suggest the following diagonal bear call spread:
- Buy to open Jan'11 $40 calls
- Sell to open May $35 calls
The structure can be done for $1.70 net debit. The trade is betting on stock falling below $35 but not below $20. If you're wrong and the stock rips higher, the trade still remains profitable as long as it stays below $55.
2) ITMN
InterMune judgement day will be Tuesday, March 9. I already own unbalanced 20-25-30 butterfly spread in April. For more on this, go to InterMune Butterfly
Analysts' commentary is very mixed and price targets are all over the place from as high as $50 and as low as $6. The stock closed around $23 on Friday. As with any biotech, you can never be even remotely assured of what's going to happen. In my personal opinion, chances of approval are high and any further gains from here will be limited given nearly 60% run the stock already had on Friday. However, that's just my opinion and the market believes otherwise. Interestingly, on Thursday at $14/share, the straddle was pricing $9 move. On Friday at $23/share, the straddle is still pricing $11.50 move. Go figure.
My inbox is full of readers this weekend asking me to provide other ways to trade the stock going into FDA decision that provide the best risk/reward. So, here they are:
1. If you believe the treatment will get approved and the straddle is under-priced despite 60% run on Friday, then I suggest the following bull ratio spread:
- Sell to open 1x March $25 calls
- Buy to open 2x March $30 calls
The spread is going for 5 cent credit. If the stock collapses, you lose nothing (and hopefully 5 cent will pay off your commissions). If the stock takes off above $35, sky is the limit.
2. If you believe the treatment will be disapproved, then you sure also believe that straddle is way under-pricing the potential move to the downside given 60% run on Friday. In that case, I suggest the following bear ratio spread:
- Buy to open 2x March $30 puts
- Sell to open 1.5x March $35 puts
The spread is going for $1.80 credit. Keep in mind this is 1.5x/2x spread. The trade starts turning a profit on a move below ~$17. If you're wrong here, you will still make money if the stock goes above $35 as $1.80 credit will be retained and puts will expire worthless.
3. If you believe the drug will get approved and the straddle is over-priced given the move the stock already had, then I suggest the following butterfly spread:
- Buy to open 1x March $20 calls
- Sell to open 2x March $25 calls
- Buy to open 1x March $30 calls
The butterfly is going for $0.60 debit. The trade will produce monster profits anywhere between $20.60 and $29.40.
4. Like many other times, if you believe FDA decision will be delayed, therefore the straddle is probably over-priced, then I suggest the following calendar spread:
- Buy to open Jan'11 $15 puts
- Sell to open March $15 puts
The spread is going for $1.45 debit. Note that I am suggesting Jan'11 options instead of April to avoid a situation where it gets delayed later than April. Also, I am suggesting $15 puts because any delay should easily bring sellers out knocking the stock down. Also, note that I have adjusted IV down to 75 for both March and Jan'11 to show true nature of P&L.
One reader asked about Mar/Apr 12.50/30 double diagonal calendar spread, similar to so many other times when we took advantage of sharply elevated front month IV. That would not work. The issue is Vega. The difference between March and April Vega on both strikes is 0.01. Meaning, the decay in IV in April will have at least 1.5x more negative impact on April options than March. Unless, the stock can be pinned exactly or very close to $12.50 or $30, the trade will most likely remain at a loss after the announcement.
Lastly, one reader asked about setting up ITMN in exactly the same way as I suggested AMLN trade on Thursday. For more info, go to AMLN Trade. My issue with this set up on ITMN is the bid/ask spread in Jan'11 options is ridiculous and they're not very liquid. I am afraid of overpaying. Also, the ratio of calendar spread against straight call would have to be very high (near 10-1) for the trade to work, which sharply increases the cost.
Folks, I am giving you the setups, you make the call. I will never advise just buying calls or puts in a biotech company waiting FDA decision in two days. If that's what you want, you're searching in a wrong place. The idea here is to make the best risk/reward play given your sentiment.
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