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Orexigen (NASDAQ:OREX) is set to receive notification from the FDA on January 31 whether or not the company’s weight loss drug Contrave is approved. This trade is complicated by the uncertainty regarding whether or not the PDUFA is delayed and what type of stock price reaction will occur under a Complete Response Letter (CRL) scenario (especially a “soft” CRL). I am trading this event using both bullish(1) and bearish strategies – this quick trade note will focus on one of the bearish strategies.

Here is the trade:

Buy 50 MAR 5.0 Puts @ 0.4562 = $2,281 Debit

Sell 50 FEB 4.0 Puts @ 0.1474 = $(737) Credit

Initial Position P&L = $1,544 Debit (0.3087 per spread)

This is a very bearish trade and assumes a hard CRL (not expected by many market commentators so this trade is somewhat contrarian). My risk is the amount I paid for the spread, or $1,544. This trade structure seeks to benefit from the differences of the levels of implied volatility between the MAR and FEB series and to hedge the PDUFA delay risk. There are several P&L and trading scenarios for this structure under the bearish outcome scenario:

(1) If the PDUFA is not delayed and a hard CRL is issued, the shares should trade well below $4.00 per share(2). In such a scenario, the trade makes around $3,450.

(2) If the PDUFA is delayed, the FEB options expire worthless; IF the new PDUFA date is prior to the expiration of the MAR series(3), implied volatility in the MAR options should increase from 170% to around 230%(4) – this implies an increase in the MAR 5 Put premium to 0.75~0.80. In such a scenario, I should make around $2,500. At this point I can close out the trade or keep it open.

(3) I also maintain the option to sell the MAR 4 Puts against the MAR 5 Puts – under this scenario, MAR 4 Puts are likely to bring in premium of 0.30 ~ 0.40 due to aforementioned increases in implied volatility. This basically creates a “free or credit” trade and my maximum profit is around $5,000.

(4) Finally, I maintain the option to simply leave the MAR 5 Puts open and free – if, under an extreme bear case, OREX trades to cash level (i.e. $2.00) my maximum profit is around $15,000.

If a “soft” CRL or no CRL is issued, I lose the full amount paid, or $1,544.

Notes:

(1) My bullish strategy is still being built but it is selling the FEB 13 Calls and buying the MAR 13 Calls for very cheap prices (i.e. a Time spread).

(2) As of September 2010, OREX had around $2.00 cash / share which is a good value metric to use under very negative outcomes. Source: 3Q-10.

(3) If a delay extends beyond the MAR expiration, I may have an opportunity to close out the trade and avoid a full loss – however, this outcome will likely result in a full loss.

(4) Implied volatility difference between the FEB/MAR 5 strikes at the time of writing this article.

Disclosure: I am long OREX.

Additional disclosure: As of writing, I am short OREX based on article and I am long OREX 13 FEB/MAR Call time spreads.

Source: Trading Orexigen's PDUFA Event