MELA Sciences (NASDAQ: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