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Arena Pharma (NASDAQ:ARNA) is a Biotech that everyone is watching into the September 16th FDA Panel that will vote on approval of its key obesity drug, Lorcaserin. The actual PDUFA date is set for October 22nd.

In the race to become the top obesity drug there are two other companies competing for ownership of the obesity drug market, a potential massive cash cow. Vivus (NASDAQ:VVUS) had its FDA Panel for Qnexa in July and shares fell from $13 to $5 as the Panel voted against approval on safety concerns, although many had seen Vivus' drug as the most effective, and the leader in the group. Orexigen (NASDAQ:OREX) is the other player, with Contrave, set for FDA Panel review on December 7th 2010 and a final FDA decision by the end of January 2011.

Despite Contrave recently showing strong results in late July, patients two to three times more likely to lose 5% to 10% of body weight as compared to a placebo, there is another event upcoming that could hurt Orexigen's stock on the viability of Contrave. On September 15th the FDA will review Abbot Labs (NYSE:ABT) weight loss drug Meridia, months after the drug was removed from the market in Europe due to data showing serious risks of heart attack or stroke. Orexigen is actively seeking a partner ahead of the FDA review.

Arena Pharma is the name that most every analyst sees as having the least risk of health problems with its drug, which could make for an easier avenue to approval, although efficacy lags competitors. Also, a larger selection of patient data (2X Vivus) as well as 2 years of trials are likely to leave the FDA Panel in a better mood this time around and satisfy the stringent safety standards. Shares are currently trading at $6.60, 10 cents below the $6.70 level where the Company made a direct offering to Deerfield (DFR) for 8.96M shares.

Arena shares are currently consolidating after a 100% gain since early July, forming a bullish pennant as volume contracts. Arena is 70% owned by institutions with Wellington and Lord Abbett Growth Fund each holding 12.6% of outstanding shares. There is a 27.5% short float in shares, 31.25 million shares, which is elevated from just 21.68 million shares short in April 2010.

The background of Arena's trial results and an in depth analysis of the fight for the obesity drug market can be found across the web, and instead of getting into the details I am more concerned with looking at ways to trade this event. For more background information, John Tucker wrote a fairly straight forward article here on Seeking Alpha.

My personal belief is that the FDA Panel will leave investors with a lot of questions and indecision, possibly a split panel which would result in some near term price gyrations, but not a huge move in either direction that is currently being priced in by the options market. I also believe that the FDA will eventually approve the drug and Arena will trade above $15/share by the end of the year. Therefore I prefer to use a short volatility strategy for September and a bullish bet on price, bearish on volatility, in longer dated options.

The key dates for Arena are September 16th and October 22nd, with September 16th 1 day before options expiration and October 22nd the day of options expiration. FDA Decisions are often best traded with options, as you can clearly define your risk and use various strategies to set up high reward-to-risk trades.

It is first important to look at what the options market is currently expecting for shares. The September implied volatility is at 302.4%, October at 241.8%, and January at 184.5%, volatility currently pricing in the biggest move in September. The September options are currently pricing in a 50% move for shares, which would target moves to $9.90 on a positive vote or $3.30 on a negative vote.

A look at some large institutional sized positioning in the options the past month points to fairly bullish longer term views, although subject to change with 3 weeks of trading remaining until the FDA Panel. I will update this article during the week of September 16th to update any changes.

  • On July 30th one trader bought 1,500 September $6/$3 put spreads at $1.13, while another trader bought 3,500 September $7 calls tied to 153,000 shares short at $7.85.
  • On August 2nd one trader bought 1,000 September $6/$3 put spreads at $1.20, while another bought 3,000 October $7 calls that were tied to 300,000 shares of stock short at $7.15
  • On August 3rd 10,000 October $12.50/$7 bull risk reversals traded (buying the $12.50 calls and selling the $7.50 puts) for a net $1.80 credit, an extremely bullish and risky bet.
  • On August 4th, another 6,100 of the prior days October $12.50/$7.50 bull risk reversals traded at a $1.90 credit.
  • On August 9th the January $10/$15 ratio call spread 1X2 was bought at a $0.15 debit for 2,800X5,600 contracts, profitable with shares between $10.15 and $19.85.
  • On August 17th, 2,000 September $11/$4 risk reversals (selling the calls to buy the puts) traded at an $0.08 debit, but tied to 135,000 shares of stock long in a collar strategy. Another trader traded the September $15 synthetic long for 1,200 contracts, a bullish bet as well.
  • On August 18th, a trader put on 1,000 September $10 synthetic long positions, a net credit of $3.05.

For the FDA Panel on September 16th one strategy to consider is an Iron Butterfly, selling the September $7/$11 call spread and the September $7/$3 put spread for a net credit of $3. The trade is profitable with Arena shares between $4 and $10. The reward/risk ratio is 3:1 and the P/L profile is displayed below:
Arena Pharma Iron Butterfly
For the October 22nd PDUFA date at which I expect approval I prefer a low risk play with the potential for high reward, emulating the August 9th strategy noted above, the January $10/$15 ratio call spread, currently trading at a $0.40 debit. The P/L is shown below and the trade does have added risks if shares were to blow past $20 on the upside:
Arena Pharma Ratio Call Spread
Another option is a diagonal call spread, a strategy I have traded with success in recent FDA decisions with both Intermune (NASDAQ:ITMN) and Vivus (VVUS). The goal is to sell the front month out of the money call and buy the next month further out of the money call for a net credit, a trade with a high probability due to the volatility decay in the front month, and can lead to big rewards if the right strikes are chosen.

A diagonal spread with Arena I like is the September/October $11/$15 diagonal call spread, selling the September $11 call and buying the October $15 calls, a net credit of $0.15. Note it is better to wait until the days leading up to the decision when volatility really explodes in the front month, and you can likely get a higher credit on the trade. The P/L of this trade is shown below, and the beauty of the trade is that is Arena fails to see a positive vote and shares are crushed, you keep the net credit from the trade and own some October $15 calls just in case of a miracle comeback.

However, the goal of the trade is for a positive move in shares, and based on the current implied move, shares should target $10, and this trade leaves room for an overshoot, profitable with shares below $12.75 in September. The best case scenario is that shares rise to just below $11 on a positive vote, and the September $11 calls expire worthless, while you will be holding October $15 calls that will gain in value, and can sell them or wait out the October 22nd decision, or even leg into another strategy. This particular trade has an 89.5% probability of profit.
Arena Pharma Diagonal Call Spread
Whether you are bullish or bearish going into the FDA Panel for Arena Pharma, I highly recommend designing an options strategy based on your price target for shares, because nothing is ever certain with these binary events, and although you can gain an edge with in depth research and following the money, it is best to have your risk clearly defined and develop an options trading plan with a high reward/risk ratio

Disclosure: No positions

Source: Arena Pharma: Using Options to Trade on FDA's Decision for Key Obesity Drug