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NPS Pharmaceuticals (NASDAQ:NPSP) is slated to report Phase III data on the company’s drug candidate targeting patients with short bowel syndrome in 1’Q 2011. I am adopting a neutral to bullish strategy to trade this catalyst given the low short interest (3.5%), the company’s financial strength and muted analyst upside projections (price targets of only $11 ~ $12 on positive news). I basically want to be involved in this catalyst, but I do not want to pay the high premiums (nor the wide spreads) for the Calls or buy the shares outright (thus taking unacceptable downside risk).

Here is the trade structure I used to fit this situation:

Sold 20 FEB 10 strike Call @ 0.82 [20 x 100 x 0.82 = $1,640 Credit (1)]

Buy 20 MAY 10 strike Call @ 1.25 (20 x 100 x 1.25 = $2,500 Debit)

Sold 20 MAY 5 strike Put @ 0.63 (20 x 100 x 0.63 = $1,260 Credit)

Position P&L = $400(2)

I did this trade for a $0.20 credit(3) – that is, I am basically being paid to do this trade. There are several P&L scenarios for this trade:

(1) If NPSP > $10 by FEB expiration, I close out the trade and pocket the 0.20 Credit.

(2) If NPSP < $10 but > $5 by FEB expiration, I pocket the expired FEB Call premium and the trade remains active

(3) If NPSP < $10 but > $5 by MAY expiration, I pocket the 0.20 Credit.

(4) If NPSP > $10 by MAY expiration, I profit from the amount over the 10 Call strike + the 0.20 Credit.

(5) I begin to lose money if NPSP trades below $4.80 (a 40% drop from current levels) – this is the primary risk to this trade structure; given the company’s financial position/situation, I feel comfortable incurring losses beginning at $4.80 on a downside outcome.

I maintain the option to close out the short Put (to hedge risk) or to use the 0.20 Credit to buy the FEB 4 Puts (trading at around 0.20; but potential to trade in around 0.15) to hedge potential losses on a negative near term news event – in such a scenario, the trade costs me zero (excluding, of course, transaction costs). After the FEB Calls expire, and assuming the trade is still active, I also retain the option to sell the MAY 12.50 Calls (transforming the position into a long Call spread), thus bringing in even more premium and further reducing risk.

Notes:

(1) Credit = cash in (i.e. you are being paid); Debit = cash out (i.e. you are paying).

(2) = (1,640 + 1,260) – 2,500.

(3) = (0.82 + 0.63) – 1.25.

Disclosure: I am long NPSP through options, as discussed in article.

Source: Going Long NPS Pharmaceuticals Through Options