Chelsea Therapeutics International (NASDAQ:CHTP) shares led the market on the day after a Food and Drug Administration panel suggested the FDA approve the company's neurological drug Northera. The stock was up an astounding 61% that day. But, it has retraced much ground since, and that says something to me.
Whenever a small biotech with a short list of drugs in its pipeline gets into Phase III trials, speculative money gathers around it. It's the result of that dream we all have, to hit the grand slam, to win the lottery, to score an overnight ten-bagger. Big moves have occurred a few times with Chelsea's shares, but after the FDA panel action, it seems investors are absolutely and perfectly unsure as to what the FDA will do later this month, when it either approves the company's drug or not, or tailors something in between. As strange as this may seem, this uncertainty can work for you just as well as long or short insight can, if you know how to play it and if you act before others do. Of course, there's no guarantee.
Chelsea has been working on a novel drug to treat a new disorder that is not very well understood. The details of the disorder, the drug, its market opportunity and competition are important but not so important to us here in the short-term. If you're a long-term investor, that fundamental information is of vital importance to you, but I'm focusing on the short-term with the strategy I'm going to outline. If you are interested in making an attempt to score a short-term win this month, I think I might have a good game plan for how to play CHTP around its FDA pivot point.
Given the wild swings in CHTP shares, reaching a 52-week high of $6.06 and touching down at $2.18 over the last year (looking solely at closing prices and excluding intraday), you can see how freely capital is flowing in and out of the shares on news. Well, Chelsea is about to receive its most important news yet. Around March 28, based on scheduling, the FDA will decide what to do about Chelsea Therapeutics' drug Northera.
Now, speculation abounds as to what the FDA will do. Those betting on a rejection or something less than approval are mostly basing their view on the near split decision vote by the FDA panel, which decided 7 to 4 to recommend Northera for approval. Those looking for approval or a qualified approval have noted a similar nod given to Shire plc (SHPGY) for its drug Midodrine.
Drug approvals for larger pharmaceuticals, like those received recently by Teva (NYSE:TEVA) and Covidien (NYSE:COV), have a sort of buffered impact to the stock prices around the decision. The buffer is produced by the company's broader product mix and the revenues generated by them, so that the valuation of the shares is less hinged to one specific new drug approval, excluding blockbuster drugs penetrating large markets in a significant way. In those cases, the stock price is based significantly on cash flows that are more clearly seen, versus the speculative analysis around various scenarios for smaller companies with little revenue on the books. For smaller biotech companies like Vivus Inc. (NASDAQ:VVUS) and Dendreon (NASDAQ:DNDN), an FDA action plays a more significant role in their stock's short-term price volatility. A look at Vivus' stock chart this year illustrates our argument very clearly.
The Game Plan
With volatility probable around the FDA decision about Northera, I say let's bet on volatility. Many investors will simply take a position long or short based on some sort of analysis or guesswork, and pray, or rub a horseshoe or something. But there's a way you can bet on the volatility that should swarm around CHTP, while leaving out the risk of being on the wrong side of the long/short trade. At the same time, you'll have a great understanding of your potential loss.
The strategy I'm going to outline therefore has a limited loss profile, while also incorporating a chance at the big gain. All CHTP has to do is move, and the bigger the move, the better. The FDA decision should not matter as much as the move that follows in either direction for us. In this case, your profit opportunity also has a hurdle, which can be surmounted by a big enough move.
The strategy employs options and is called a "straddle." In this case, it would be a long straddle, incorporating the purchase of a call option and a put option with the same exercise price (at current price or at-the-money) and the same expiration. Our burden to overcome before we book a net capital gain is simply the total cost of both options. The price of the options will incorporate the factors of the current stock price, the strike price, the time to expiration, and the stock price volatility expectation. Since we are nearly sure a determination will come at the end of March, we can limit the cost tied to the expiration date. However, in the case of Chelsea, some are anticipating it could be asked to provide more data, meaning the decision might not come until later. You can consider such a decision as a diluted rejection, which could work against volatility seekers a bit.
The most plentiful open interests in CHTP calls and puts exist at the April expiration, excluding the irrelevant March expiration date. So, we'll find the most efficient pricing environment there, but we carry risk tied to a potential rescheduling that might occur. If the FDA decision is pushed out, the stock has little catalyst to drive it before April expiration (save perhaps road show activities), meaning we would likely lose capital on our investment. If you feel this is an important enough concern, you might look to June expiration or beyond.
The stock trades around $3.50 as of the March 8 close, but options exist for CHTP at strike prices on dollar points, as far as I've seen. So, we're finding options costs differ between calls and puts on the same expiration price, as it is out of the money for one and in the money for the other side of the bet. But since the current price of the stock sits right in the middle, we could buy the in the money calls and in the money puts or the out of the money calls and puts, at $3 and $4 expiration prices or $4 and $3 expiration, respectively. This would help us keep our dollar investments even on both ends at equal contract counts. Though, if you have a leaning long or short, you could taint the pure straddle by taking a position that leans long or short, depending on what you want to do.
If you buy the in the money options, you are going to pay a premium for that. If you buy the out-of-the-money calls and puts at $4 and $3 strike prices, respectively, you'll have a greater bar to surmount before making money but you'll be compensated for the risk should things pan out as we hope. For those out of the money options, you'll find the last traded prices at $0.70 and $0.60.
In the case of Chelsea Therapeutics, I think your best value play over the short short-term is a long straddle. How you design it is up to you, but you should be able to eliminate your risk of being on the wrong side of the news while still capitalizing on the very likely volatility around the news by employing this options strategy.