Using Options to Capture Dendreon's Volatility

Dendreon Corp. (DNDN),which is in the Biomed/Gene industry, is seeking FDA approval for its prostate cancer vaccine Provenge.

On March 30th an FDA panel announced that data showed that Provenge is safe and effective. On that news the stock soared from the previous day's close of 5.22 to as high as 18 closing just under 13. Since then the stock has been all over the place, to as high as 25 and as low as 13.

The volume as one would expect has risen dramatically, and so has the implied volatility in the May options. The implied volatility in the May options began to rise several months before the announcement, going from approximately .75 to approximately 1.25 by the beginning of December of last year. By the middle of February it had risen to approximately 1.70. By the beginning of March it spiked to around 2.40. On March 27th, three days before the FDA announcement, the volume in the May 5 strike call was over 20,000 contracts. And on March 28th, just two days before the announcement, the volume rose to almost 29,000 contracts, which is about 25 times the normal volume.

This shouldn't come as a surprise, though, as insider trading goes on every day.

As of Friday's close of 19.39 the implied volatility on the closest May "at the money" (20 strike) straddle was a staggering 4.40. This is in anticipation of the FDA ruling on Provenge sometime by May 15th.

The question is what to do.

The may 20 straddle could be sold on the close for a whopping 12.20. If the straddle was sold for 12..20 the downside protection or breakeven point on the stock would be 7.80, the upside breakeven point would be 32.20. So if the stock is between these two prices at May expiration the short straddle would be profitable, the highest profit (12.20) being of course at 20.

According to a widely used "stock price probability calculator", using a volatility of 4.40 the probability of the stock being above 32.20 at May expiration is about 26%. The probability of the stock being below 7.80 is about 13%.

The May 17.50 straddle, which is almost two points "in the money", could be sold for 11.70. That's selling the bid on both options.

In this case, the downside breakeven point would be 5.80. The upside breakeven would be 29.20. According the the "stock price probability calculator" the probability of the stock being above 29.20 is about 30% and being below 5.80 is about 7%.

If a covered write was done by buying the stock at 19.39 and selling the May 20 call for 5.60, which was the bid on the close, the debit for the spread would of course be 13.79. The downside protection or breakeven point would be 13.79. Therefore, if the stock is trading above 13.79 at May expiration there would be a profit. If the stock is above 20 at May expiration the profit would be 6.21 or around 45%. Or you could simply sell a cash covered May 20 put for 6.50, which was the bid on the close. This is the same as doing the covered write. However, selling the put would increase the downside protection to 13.40. If there is a return it will be slightly higher, as well. According to the "stock price probability calculator" the probability of the stock being above 13.40 is around 68%.

If a lower strike call was sold against the stock, then the downside protection would increase and the return would be less.

The big question, of course, is where will the stock be after the FDA ruling. That's anybody's guess.

Are these spreads worth the risk? With a small amount of one's investable funds, I believe the answer is yes.

Disclosure: Author has a long position in DNDN

Comments

[Lockstep In...:]

I don't think this article sufficiently addresses the potential movement after the decision. With over 30% of the shares shorted currently, a straddle is the low risk option because the energy potential. With so much tension on the stock price, whatever the decision, the stock is going to go bonkers. To cover that many shares in such a short period of time the volatility index will increase even beyond what has been seen thus far just to close all of the positions that have been built.

2007 May 07 06:01 PM

[Ishmiel Kapur:]

I wrote an earlier blog on DNDN too, and I personally have a bear view based on my research. I have received a lot of emails on my own blog at BullPoo.com (some positive, thank you, and some not so positive, which I fairly respect). I think the best is to see what will happen before May 15. There will always be two sides to a coin, and I'm one of many with the bear view. I failed to disclose that I do not own any positions in real-life, just short positions on my virtual account with my blogs.

2007 May 08 01:13 AM

[Ray Wollney:]

Christian, thank you for your comment
I agree that the potential for a big move is there. This is why the implied volatility in the May options is so high. In anticipation of the FDA ruling the May "at the money" and slightly "in the money" calls and puts have been bid up to extremely high prices. Since I wrote the above article the implied volatility in these options has risen even more.
I'm not sure what you mean when you say the straddle is a low risk option. Buying or selling the straddle is a high risk option. This is not for risk averse.
As for the large short interest no one knows if most of that is naked shorts or shorts tied to options in some way ie a reverse conversion. So I'm not convinced that the short interest is a big deal. Also the if the FDA rules against Provenge then the stock will surely go down which would not restult in a short squeeze.
The question here is whether the straddle is a buy or a sale. We'll have to wait and see.
Thanks,
Ray Wollney

2007 May 08 05:53 PM