Arena Hedges, Shorts And Retail Investors - Oh My

| About: Arena Pharmaceuticals, (ARNA)

There is no secret that Arena Pharmaceuticals (NASDAQ:ARNA) is a favorite investment for retail investors. This can be a blessing as well as a curse. It is not necessarily a case that the Street is smarter than a retail investor, but more along the lines that the Street has more dollars to expend on influencing its position, desires and will. That being said, regular traders are typically a bit more savvy than your average retail investor. Do hedge funds and Wall Street traders have an advantage? Yes. Can a retail investor make money? Yes. You simply need to understand the dynamics of the game, set appropriate goals and stick to them.

Whenever an equity becomes a favorite of retail investors there is inevitable discussion about manipulation, short interest, and hedge funds. This discussion is typically the fodder of message boards, a home to retail investors seeking information about an equity. While there are indeed times when things can look heavily manipulated, it is not as if a conspiracy against retail investors exists. The fact of the matter is that a conspiracy does not have to exist because all that the Street or a good hedge fund needs to do is keep its finger on the pulse of the retail investment community and understand what the retail side of the house is thinking.

Case in point. Arena retail investors can be an excitable and passionate bunch. It seems to be in the DNA of the retail crowd to want to look at the positives of an equity and perhaps even exaggerate those positives in order to arrive at a price point that delivers a good profit. Simply stated, many investors convince themselves that the good attributes of a company will deliver a great share price improvement but ignore the negatives that also impact an equity.

If you look at Arena message boards after the FDA approved the anti-obesity drug Belviq, you would see scads of retail investors assigning a $20 to $30 price per share on Arena. Now here we are 9 months later with a stock price of $8.70 (down from $13 at FDA approval). At first it was that the DEA scheduling would be the catalyst to drive the stock to new highs. The cycle of excitement and disappointment happened each subsequent month in hopes that the DEA would assign a schedule to Belviq. The thought process was that once the DEA assigned a schedule the product could launch and the equity would rise. The same dynamic has now started with the approval process in Europe.

I often see Arena investors say that this equity will "skyrocket," will "take off" and will "be off to the races" when Belviq gets DEA scheduling, get European approval, or launches here in the United States. These terms are great in theory but in reality lack definition. Many investors actually refuse to exact expectations for fear that they may not be reached and alas the equity they felt was an easy quadruple has difficulty becoming even a double.

A savvy hedge fund is well aware of this retail investor dynamic and can play the market to its advantage. Some retail investors are savvy as well, and can play the cycles on a smaller scale. There have been many times where I have "confronted" a person commenting on an article I write with lofty words like skyrocket. I have yet to see these "perma-bulls" ever respond and narrow down skyrocket into a dollar figure and time frame.

The fact of the matter is that Arena's Belviq has been assigned "blockbuster" status by many retail investors as well as writers. The truth is that the data we currently have to consider perhaps warrants a more conservative approach. Many do not even define "blockbuster," leaving a wide range of what a blockbuster may actually be. How can an investor make smart decisions when they refuse to classify early on exact standards and goals?

I have stated many times that Arena investors need to monitor competitor Vivus (NASDAQ:VVUS) and its already launched Qsymia closely. The reason for this is not because one drug is better than the other, but because Vivus is already selling Qsymia and no matter which drug you feel is better the sales of Qsymia can be used as a measuring stick to understand and set expectations for Arena's Belviq.

In response to suggesting that investors watch Vivus closely I typically get replies that go on and on about REMS, pregnant women, pharmacy availability, European approval, and the partnership with Eisai. What investors need to do instead is look at the expectations that were placed on Vivus and use that as a measuring stick for Arena. This is what the hedge funds and shorts do, as a retail investor you owe it to yourself to do it as well.

Time and time again I see passionate Arena retail investors say that the Vivus launch was a failure. Success or failure for the Vivus launch is not really the issue though. If you are invested in Arena and not Vivus you need to look at what is happening in the sector and come to an estimate of how much better you feel Arena can do.

OK, passionate Arena longs, take a moment to ask yourself some questions.

If Qsymia selling 15,000 scripts in two-and-a-half months is failure, what is success?

Should we be looking for Arena to sell 30,000 scripts in three months?

Perhaps the number is 45,000. Could it possibly be 60,000?

What is blockbuster? Is that 75,000 in 3 months?

Without a concrete definition there is a lot of room for interpretation, or worse yet dialing down one's own expectations without admitting to yourself. Unless, as an investor, you have concrete levels of what you consider acceptable results you are more and more likely to be on the wrong side of the trade or, worse yet, a day late and a dollar short.

With all of that said, let's look at the short interest in Arena. It was less than a month ago that I wrote, "Arena Short Interest Declines - So Do Hopes Of A Squeeze." I was taken to task by several passionate Arena longs with that article. Three days after that piece was published I sold off half of my Arena position at a 40% gain. Since that day Arena has tumbled from about $10.50 to $8.60. I was able to make that trade because I have specific goals for Arena regardless of what hedge funds do, short interest, or anything else.

I have stated many times that there are several hedge funds that see Arena as a great short. The problem these hedge funds have is that there are also many that see the potential in Arena and have gone long. A virtual battle line has been drawn. It is a tug-of-war of sorts. Both sides can claim small victories at various times on an overall basis, but the savvy traders are claiming victory all along while many retail investors are "long-and-strong" without specific targets and goals.

Yes, Arena has potential. In fact it has a lot of potential. It also suffers from expectations that are very high. Here is the issue. Even with a successful launch the high expectations of some will not be met. These are the types of investors that are most likely to miss the peak and then complain of manipulation when the equity makes a natural retracement. Whether these investors realize it or not, they are the catalyst that allows savvy traders with more money to score big gains.

The current short position, dated January 15th, on Arena stands at 53 million shares with only 3.6 days to cover. This short position is not high and it is not low. In fact I expect to see the next short report to show a decline. Remember that Arena was above $10 on January 15th. With the equity now in the $8s, the short side can cover positions and reset while waiting for the next side of the trade. This cycle continues again and again with savvy active traders making money long and short. Meanwhile a passionate retail investor sits on the sidelines, shares grasped in his hand wondering what is happening and why this "blockbuster" drug has not "skyrocketed," "gone off to the races" or "gone to the moon."

Look back at any Arena message board and you will see retail investors predicting a "skyrocket" on FDA approval, DEA scheduling, and now European approval. Reality is that we have now had three false starts on this "skyrocket," but somehow the next time is going to be the big time where Arena will rise for days on end and deliver investors to the utopia of $30 per share. At what point does an investor take the bull by the horns and set parameters for their investments?

Do yourself the biggest favor you could ever do with this equity. Outline your expectations for the first quarter of Belviq prescription sales results now. What is acceptable? What is good? What is great? Do not set goals by share price. Set goals of company performance.

Each investor has their own expectations and the numbers will differ from person to person. This outline of expectations needs to be in writing. By putting it in writing you cement the expectations and cannot revisit your "thoughts" with one justification or another. Writing these expectation levels down makes you accountable to yourself and not finding some invisible bogey man in short sellers, active traders, or hedge funds.

If if you are ultra passionate about this equity use Vivus as a barometer. Vivus did 15,000 in about 2.5 months. Assume Vivus will get to 20,000 in 3 months and work from there. Should Arena do twice as good in your mind? three times better? The key to investment success is knowing that there are many sides and facets to the market. Your success is not determined by these forces, but rather your ability to understand them and set your expectations and goals accordingly.

Personally I feel that Arena can be a success. It is why I held onto half of my position. With the sale of half of my shares at a 40% profit I have mitigated my risk, ensured a profit on the sold shares, and have some cash left to react and buy in again if I see a run in the future. The difference between successful investing and hopes and dreams is self accountability. Set the stage for success by making yourself accountable. If Arena turns out to not be the four-bagger you had initially thought at least set the stage for locking in a two-bagger.

Shorts, hedge funds and active traders are a part of the market. The sooner you can see those other facets the sooner you will become a more savvy investor. We all hope our investment decisions make us money. Admitting that perhaps we had expectations set to high is not easy. However, a successful trade is not always hitting the top. It is making money.

Disclosure: I am long ARNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no position in Vivus