Macro Tsimmis

intelligently hedged investment

BUY Dendreon (DNDN) puts and calls—straddle play

Posted by intelledgement on Fri, 09 Mar 07

OK, first we suggest you check out this thestreet.com article which summarizes what is at stake for Dendreon and their prostate cancer product, Provenge, at the 29 March FDA advisory committee meeting.

Essentially, if Provenge is approved, DNDN stock, currently around $4, is likely to double or triple at least on the expectation that Dendreon will get revenues starting this year and be profitable by 2008. If the product is not approved, the next window for consideration would be when the currently-enrolling Phase III test results are available, which would be sometime after late 2008 or early 2009 at the earliest, and in the meantime to keep the doors open the company would have to raise more money which means at best—assuming the product is eventually approved, which obviously could not be guaranteed—more dilution for existing shareholders. In this case the stock is likely to plunge 50% or more.

The Street (that is, the common wisdom, not thestreet.com) seems to feel the FDA is more likely not to approve Provenge. There is a huge short position, meaning that many traders are betting against approval and if they are wrong, they will all have to buy stock to close out their positions, which will likely exaggerate what would already be a sharp appreciation in share price. The ISOP is long DNDN so obviously we tend to think it is more likely to be approved than not. But today we are taking another position utilizing short term options that is designed to take advantage of this binary event on 29 March. In true hedge fund fashion, we are purchasing a straddle; if the advisory committee recommends approval of Provenge, we will do insanely great and if not, our losses will be mitigated (and if the stock falls low enough, we might even make money that way, too).

We are buying Apr $5 DNDN puts (UKOPA) and Apr $5 DNDN calls (UKODA).

Each UKOPA put option gives us the right to sell 100 shares of DNDN on or before the date the option expires (13 Apr 07) at $5/share (the “strike price”). With the stock currently at $4, these puts are going for about $200 each (that is, we have to lay out $2/share now for the right to sell the stock at $5 anytime between now and 13 Apr). Right now these puts are “in the money” because they give us the right to sell DNDN stock for more than it is worth on the open market. The options are worth more than the $1 difference between the current stock price ($4) and the strike price ($5) because of the possibility that DNDN could fall further between now and 13 Apr. Should DNDN stock decline in value between now and 13 April, then the options will be worth more than $1; should DNDN stock go up, then these options will be worth less. If DNDN stock is worth more than $5/share on 13 April, then these options will expire worthless, as obviously no one would pay anything to acquire the right to sell a stock cheaper than the price he can get on the open market. Essentially, DNDN has to go down another dollar (to $3/share) by 13 April for us to break even on these options, as they will then be worth $2 each, which is what we are paying for them today. If the stock declines more, we will make a profit.

Each UKODA call option gives us the right to buy 100 shares of DNDN on or before the date the option expires (13 Apr 07) at $5/share. With the stock currently at $4, these calls are going for about $100 each (that is, we have to lay out $1/share now for the right to buy the stock at $5 anytime between now and 13 Apr). Right now these puts are “out of the money” because they give us the right to buy DNDN stock at a higher price than we can get it on the open market. The options are not worthless, though, because of the possibility that the stock price could exceed $5 between now and then. Should DNDN stock go up in value between now and 13 April, then the options will be worth more; should DNDN stock goes up, then these options will be worth less. If DNDN stock is worth less than $5/share on 13 April, then these options will expire worthless, as obviously no one will pay to acquire the right to buy a stock at a higher price than he can get on the open market. Essentially, DNDN has to go up $2 (to $6/share) by 13 April for us to break even on these options, as they will then be worth $1 each, which is what we are paying for them today. If the stock goes up more, we will make a profit.

In point of fact, we never intend to exercise these options; instead our plan is to sell them—hopefully for a profit—before they expire.

The puts are currently asking $2.10 and the calls $1.05; there is healthy open interest for both (meaning there are lots of trades every day and thus it is easy to buy and sell them at the market price). Thus we will buy five puts and ten calls. Note that because we are buying both puts and calls, the stock has to move up or down farther for us to make an overall profit that it would if we just bought one or the other. This is because if either the puts or calls are in the money, by definition the other position is worthless. So if the stock goes up, even though we only spent $1,000 to buy the calls, we have to make more than $2,000 on them to make a profit overall because we we need to cover the $1,000 we spent on the now-worthless puts. Normally, you would probably do better just to buy one or the other based on your best guess which way the stock will move. But the straddle makes sense here because [a] the decision could easily go either way and [b] whichever way the decision goes, the stock is likely to move significantly in one direction or the other. With a “straight” play—either buying or shorting DNDN, or just buying calls or puts but not both—there is a close to fifty-fifty chance you will get burned. With our straddle, you can actually come out ahead—or at least cut your losses—no matter which way the decision turns.

Here is how we expect this to play out. If the FDA advisory committee recommends outright approval of Provenge and the stock goes up to $10 (halfway between doubling and tripling), then the puts expire worthless and the calls are worth $500 each for a profit of $3,000. If the stock reachs $12, then the calls are worth $700 each for a profit of $5,000.

If the FDA advisory committee does not recommend that the agency approve Provenge and the stock tanks the expected 50% to $2, then the calls will expire worthless but the puts will be worth $300 each for a net combined loss of $500 on both trades. If the stock goes down to $1, then the straddle will breakeven; at prices below $1 the straddle is profitable.

Of course, the risk is that there will be some sort of grey result from the advisory committee meeting that only modestly boosts or hurts the stock. For example, there might be a delay in the decision, or the committee might recommend Provenge be granted limited approval for use with terminal prostate cancer and no viable treatment alternatives with full approval pending the results of their currently enrolling Phase 3 study. This latter eventuality—which we actually think is the most likely—would probably afford the company enough revenue to avoid the need for more funding through 2008, but not enough to turn profitable until when and if Provenge is fully approved. At any DNDN price between $1 and $7, the straddle loses money. Worst case is the stock going up from the current $4 to $5, in which case both the puts and calls expire worthless.

Our expectation, however, is that conditional approval would still get the stock up close to $8 and that the prospects of any other non-decisive outcome or a delay at this point are remote. In any event, going with later options is more expensive and thus the potential ROI on a straddle is reduced considerably. This is a relatively unusal situation where the timing of an event that is likely to have a huge effect on the stock price is known about beforehand: you don’t get better straddle opportunities than this.

BTW, to purchase options (and/or to sell stock short), you generally need to have established a margin account with your broker. It is a good idea to do this even if you never intend to buy on margin (which indeed we recommend you never do) so that you have the flexibility to transact such a trade. If you took the same $2,000 we are deploying here and just bought DNDN stock outright at $4, if the stock tanks to $2 you are out $1,000 while our straddle play is down only $500…and if the stock rockets to $10, you have a profit of $3,000 while our straddle play is up $5,000…at $12, you are up $4,000 and the straddle is up $7,000.

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