Vivus: My Cautionary Tale on Using Options

Dec.20.10 | About: Vivus, Inc. (VVUS)
By Ed Leventhal
I just saw the following Market Current news flash on SeekingAlpha.com regarding Vivus (NASDAQ:VVUS), a company that has been trying to get FDA approval for an obesity drug called Qnexa:

7:54 AM Vivus says it has applied to market its Qnexa obesity drug in the EU. The FDA rejected Qnexa in October, but investors have remained bullish on the stock. Shares +4.1% premarket.

My experience with VVUS has been a very interesting one, and how I've managed my exposure to this stock, I believe, can be quite instructive to readers who are considering the use of options as a hedging tool.

Before sharing these thoughts, as Richard Nixon often said: "Let me make one thing perfectly clear" ... and this is critically important for readers to note: Options are not for everyone.

They can be quite dangerous if not well understood. Readers should not take this article as a message to get involved in options. Each investor needs to decide for themselves as to the appropriateness of options to their unique investment profile and financial situation. Before getting involved in options, investors should take extensive training and even then, start with paper trades in order to test run their level of know-how.

What you are about to read is simply an anecdote on how I decided to use options to express my views on the risks embedded in owning VVUS. I'll also note that I could share many (too many!) anecdotes of option experiences that did not work out well at all! And as a result, options are not a primary tool in my war chest, but they are one of the tools that I draw on from time to time. This was one time where it happened to work out ok, but that's not the relevant point. What I hope readers will draw from this article is merely a general thought process about risk and some possible ways to deal with it.
April 16, 2010: I bought 500 shares of Vivus @ $9. (My research on the company indicated that their chances of passing the pre-FDA screening committee meeting set for July 15 was quite good).

May 11, 2010: I took profits on 200 shares at $12.39. (By this time, the market was rife with talk that the upcoming July meeting was very likely to go well).

July 13, 2010: Two days before the July 15 committee meeting about VVUS, the stock got as high as $12.75 and closed at $12.44. I was still sitting with 300 shares. The market was abuzz with talk that the committee meeting would go well and there were all kinds of suggestions about how high the stock might go if approved. At times like that, I often get concerned that there’s too much “hype” and I worry about what happens if the “unlikely” event happens, in this case, what if the committee rejects the drug (Qnexa). So I took the following option position as a hedge:

I sold out-of-the-money calls struck at $16 … in this way, if the market soared, I’d gain, but would be capped at $16, which given my basis, would be a great return.

I used the proceeds to buy a put-spread in order to protect against a big downward move. I bought puts struck at $11, and sold puts struck at $9. The proceeds of my sale of the call fully covered the cost of this put spread ... so for no cash outlay, I was protected on the downside and had room to gain on the upside. I liked those return characteristics.

July 15, 2010: On the day of the meeting, the committee surprised the markets and rejected the drug until further trials could be done over the next year. The stock closed the next day at $5.41!! (down approx 60%!!)

The upshot? I was left in a position of holding 300 shares with an effective cost of $4.61 (after taking into account the profit on the earlier sale of part of the position, keeping the call option proceeds, and gaining on the put spread).

I continued to like the company’s prospects, so I held onto the 300 shares ... which today are priced at over $9/share.
Again, I share this anecdote as a thought-provoking exercise for readers to consider what to do especially in situations of very extreme expected outcomes, and not in any way as a recommendation as to how to operate in general nor with regard to VVUS today. If anyone hasn’t already gotten the message, and instead decides to run out and get fat, dumb and happy using options, then they’ll definitely need to re-read all the warnings in this article which frankly could be called the Qnexa for such gluttonous behavior!

Disclosure: I am long VVUS.

Additional disclosure: Positions can change at any time without notice.
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