MELA Sciences (MELA) is slated to face an FDA Advisory Panel for MelaFind on November 18.(1) Advisory Panels always make interesting trades and this is no exception. Here is the situation:
- NOV options are currently pricing in at least a $4 move; Put option implied volatility is off the charts, +500%
- Short interest is nearly 35% -- in these situations (i.e. Advisory Panels), there is usually a great deal of short interest, around 10~15%; whenever a company has greater short interest than this, it makes me very nervous to be long the name as this is big money short interest
- Having said that, some analysts have price targets of around $14 per share, a 100% move higher than current price levels
- There are no shares or limited amounts of shares to short; in addition, borrow rates are fairly high at around 95% per my broker
- There are huge implied volatility discrepancies between strikes, puts, calls, etc.
In a high volatility, binary situation, where the outcome is highly uncertain, I often like to employ a neutral structure which allows me to speculate both short and long with a very wide price range and limited downside risk. Here is the example structure I used and the associated risk chart:
- Buy 100 3 Strike NOV Put @ 0.37
- Sell 100 9 Strike NOV Put @ (4.03)
- Buy 100 10 Strike NOV Call @ 0.63
- Sell 100 4 Strike NOV Call @ (3.01)
click to enlarge
This trade appears to be (is) an arbitrage – the most I can lose based on the position is to gain $400 -- if all goes well, and MELA stays within the $7 range, I make over $10,000…risk free; if not, I still make $400. After I set-up and executed the trade, I became very paranoid: how is it possible to pull off an arbitrage as a non-institutional trader? Even institutional traders have difficulty achieving this type of arbitrage.
One reason, of course, is early assignment risk on either the short call or short put positions. I was cognizant of this risk going into the trade but considered the risk low at the time. The biggest early assignment risk was with the 4 strike call position: the Delta was hovering around 90 at the time – early assignment risk would increase substantially over this level nearing expiration. The short put Delta was well below this level (the shares traded at around $7 during the initiation of this trade). Of course, within 2 days of putting on this position, I was assigned a portion of the calls: I was now short the shares and my structure was at risk of being out of balance. In order for this structure to work, it must remain in balance -- if one leg goes out of balance, risk increases substantially.(2)
Rather than topping-off the structure (by selling, again, the number of calls to put the structure back into balance), I reduced the other legs of the trade to bring the structure back into balance (at a loss). So much for the risk free trade!
- Briefing documents expected by November 16.
While the risk at expiration is essentially the same, the short share position risked a potential forced buy-in and associated fees/charges (b/c the shares were/are either not available to borrow or very hard to borrow at the time) and the need to fund the high daily borrow rate. An undefined buy-in event in this structure with this type of event approaching is unacceptable risk (for me).
Disclosure: Neutral position through MELA options