While the markets are crashing, it’s a good time to add to medium term catalyst trades. One name I am looking at is Avanir Pharmaceuticals (ticker: AVNR).
The company’s lead Phase III candidate, Zenvia, is a drug targeting Pseudobulbar Affect (PBA) and according to the company, targets an underserved market of up to 2 million patients where there is currently no approved therapies (i.e. “no competition”). In 2006, the FDA issued the company an Approvable Letter, and following discussions with the FDA, AVNR agreed to conduct a confirmatory Phase III trail under an SPA for Zenvia. In August 2009, the company finally reported solid top-line data to address these FDA concerns. AVNR recently stated that they expect an FDA decision on Zenvia by October 30, 2010.
For this trade, I assume some “stability”(1) in AVNR's share price going into the FDA’s decision (assuming there is no outlier event):
- AVNR currently maintains a cash balance of approximately $46.3 million that is expected to fund the company until commercialization of Zenvia by 2Q’11 (assuming approval) – funding therefore shouldn’t be a problem over the trade time horizon
- The company seems to be finished doing secondary offerings(2)
- At $2.50, AVNR is trading in the middle of its technical range of $1.75 and $3.50
- Investor/trader interest in the coming FDA decision should support if not elevate the shares into the FDA decision
Given that options recently started trading on AVNR, there are several angles to trade this impending catalyst event. One very simple approach is to use a covered call strategy. Normally, I am against the covered call strategy for small cap biotech as the premium sold against the shares will normally be insufficient to cover losses on the shares in a negative outcome situation. Due to the fundamental and technical factors specific to this Company, however, I believe this makes a good risk/reward trade.
Here is the trade based on 1,000 shares:
- BUY 1,000 AVNR shares @ $2.50
- SELL 10 AVNR DEC 2.50 Call @ 1.10
- Net Debit: 1.40 or $1,400
From an upside perspective, this trade offers a 44% return assuming AVNR shares close above the strike by the expiration date. The key to this trade, however, is to understand the downside risk. On a break-even basis, the trade begins to lose money below $1.40 (at expiration). A negative outcome from the FDA could easily push the shares below this value.
How low? Based on the 2006 sell-off, and adjusting for share issuance, this level could be around $0.32 a share. The company’s cash per share, however, will likely be higher than this value at the time of the announcement which should provide additional support: I would assume around $0.40 per share. This is likely a worst-case scenario (where the risk/reward is still slightly in my favor).
If later down the road I wish to avoid this binary result, I always maintain an option to trade out of the structure on October 29 – the day before the expected data. Although I do not know what the share price will be at that time, I am fairly confident that implied volatility, relative to current levels, will be elevated. I assume an implied volatility level of around 250% (compared to current levels of 150%). I perform three scenarios based on technical trading range:
Price (October 29, 2010)
Based on this quick analysis, this trade seems to have favorable risk/reward characteristics.
(1) Stability is a relative term. In this situation, I assume AVNR to stay within the trading range I have defined in this note.
(2) The company has during the past several years been pounding existing shareholders with secondary offerings that subsequently increased shares outstanding from around 31 million in 2006 to around 95 million as of March 31, 2010. I would expect no additional secondary offerings into the FDA decision (unless, of course, the shares rise significantly).
Disclosure: Author is long AVNR stock and is short calls