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DepoMed (NASDAQ:DEPO) is expecting to hear from the FDA on January 30, 2011, on whether or not its drug candidate DM-1796 for the treatment of post-herpetic neuralgia is approved. I am using a neutral / bullish structure for a credit to trade this situation. This structure employs several different series (i.e. months) and both calls and puts and may appear to be a bit convoluted – there is, however, an underlying logic to the structure.

Here is the trade:

Sell 30 FEB 7.5 strike calls @ 0.583 = $(1,750) Credit
Buy 30 MAR 7.5 strike calls @ 0.75 = $2,250 Debit
Sell 30 SEP 2.5 strike puts @ 0.21 = $(630) Credit

Position Initial P&L = $(130) Credit

The call part of the structure is basically a FEB/MAR time spread; i.e. selling the FEB 7.5 strike call and buying the MAR 7.5 call. This part of the trade is meant to take advantage of the higher implied volatility in the FEB series (attributed to the PDUFA event) and selling it against the lower implied volatility in the MAR series – I am basically financing the purchase of the MAR calls by selling the FEB calls. The key risk in the FEB/MAR call structure (on a stand-alone basis) is if DEPO’s share price settles above $7.50 by the expiration of the FEB series – given the PDUFA news, this is a possibility. In such a scenario, and on a stand-alone basis, I would lose the debit portion of the time spread, or in this example, approximately $500 (or 0.167 per spread = 0.75 - 0.583). In order to hedge this risk, I sold SEP 2.5 strike puts for 0.21 – the trade thus results in a credit.

My thinking is that if the drug is approved, and given the substantial run-up in the shares over the past several months, DEPO will likely experience a slight sell-off or a limited initial share jump (I could of course be wrong). If the shares do in fact jump above $7.50 (and remain there upon FEB expiration), my loss is partially covered by the sold SEP puts(1). If the shares do not settle above $7.50 by FEB expiration (and the FEB series thus expires worthless), I maintain nearly fully paid for MAR 7.5 Calls. Recent analyst estimates see the shares trading to $9.00 – under this scenario, my profit is approximately $4,500. I also maintain the option to sell the MAR 10 strike calls thus bringing in more premium (increasing my profits) and further reducing risk.

The key risk with this structure is a significant downside move – I begin to lose money (by expiration)(2) a little below $2.50 a share (a greater than 40% drop from the current price level). I feel comfortable with this risk given the company’s relatively strong financial position, existing and growing revenues and most importantly, another major catalyst event(3) in the 4th quarter of 2011. The shares are likely experience another run-up into said data – if not (i.e. if the shares trade around or below $2.50), I am a happy buyer of the shares into and ahead of the 4Q’11 Phase III data.

Notes:

(1) I say “partially” because in order to fully cover the loss, you need to wait until the puts expire worthless in SEP (if in fact they do). A jump in the shares and a sustained elevated share price, however, will cause the SEP puts to plummet in value – a great time to cover at a later date if desired.

(2) It should be noted that a significant downside move, even above $2.50, can produce mark-to-market losses.

(3) Phase III data for Serada for the treatment of menopausal hot flashes.

Disclosure: Author long Depo, long calls and short puts as discussed in article

Source: How to Trade DepoMed's PDUFA Event