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In the biotechnology sector, the market often chooses to focuses on a particular disease targeted for treatment, such as cancer, or hepatitis C. In addition to those diseases, there is currently a very sharp focus on obesity treatments.

While Vivus (VVUS) is likely the lead obesity-focused biotechnology company, with its Qnexa nearing an FDA decision, we would like instead to focus on Arena Pharmaceuticals (ARNA).

Arena has had an impressive run year-to-date, with shares up nearly 63%, as optimism grows over the approval of Lorcaserin. However, this gain still pales in comparison to the rallies seen by Vivus and Orexigen (OREX), its peers in the obesity drug space.

There is much debate on whether or not Lorcaserin will be approved, both here on Seeking Alpha, and the broader market as a whole. We however, are not examining the medicinal and clinical properties of Lorcaserin in this article. How can that be? Because we are proposing an investment in Arena Pharmaceuticals that is backed by options, which dramatically alter the investment thesis.

We believe that placing a collar on a position in Arena could be a wise investment. Before we continue, we must note that this position WILL NOT generate profits on the same scale as if one were to simply hold the stock. Your upside is capped. But so is your downside. Hence, the collar. It limits your gains and losses to a potential range. For those unfamiliar with what an options collar is, it is a combination trade where you are long the underlying stock, sell a call against it (covered call), and purchase a put as well.

How is that we can propose an investment in Arena without examining the underlying properties of Lorcaserin? It is because the use of options turns this into a simple binary trade. Either Lorcaserin is approved, or it isn't. The FDA will make its decision based on the data it has. Before we get into the technical details of our trade, we must first review sentiment.

Lorcaserin: Mixed Opinions & Upcoming Events

While the markets may believe that approval is likely, analysts are mixed in their opinions. Jefferies is quite bearish, with an underperform rating and a $1 price target. The firm thinks a 2012 launch is unlikely, and is worried about CV hurdles at the next FDA meeting. Leerink Swan is more upbeat, saying that Lorcaserin has an acceptable efficacy and safety profile that should lead to approval. Needham is worried about competition from Qnexa, and Piper Jaffray downgraded the stock recently from overweight to neutral, citing its recent surge. The firm set a $2.50 price target, and noted that if Lorcaserin fails to be approved, shares could fall to $1.

In the months to come, Lorcaserin will face several key FDA decisions. With the EMA (European Medicines Agency) already reviewing the drug, a date of May 10 has been set to review it, and the drugs PDUFA is June 27. With those 2 dates in mind, we will now discuss the technical details of this options trade

The Trade

Many people see options as leveraged versions of stocks designed for reckless speculation. But they are nothing of the sort. Used properly, options can be conservative hedging techniques, which is why they are being used here. We would like once again to remind readers that this trade is meant to cap both profits and losses. Investors more bullish on Arena should simply buy the stock, or call options on it.

We will be using May options, which expire on May 19, so that the FDA review on May 10 can be included. In addition, the premiums for April options are such that there is little reason to consider them.

We are combining the May 19 $3.50 call and the May 19 $2.50 put. Because this is a collar, the underlying stock must also be bought. Below we break down the transactions involved, and the cost basis of the stock. For simplicity, we will illustrate this with just 100 shares, but any multiple of 100 can be used. Commissions are excluded in these calculations, and prices are current as of this writing.

Arena Pharmaceuticals Collar
TransactionCostNet Cost per share
Buy 100 shares of Arena Pharmaceuticals306$3.06
Sell the May 19 $3.50 call for $0.89-89$2.17
Purchase the May $19 2.50 put for $0.7171$2.88

Given that we bough Arena shares for $3.06, and our cost basis is $2.88 per share, we have an immediate profit of 6.25%. And, our trade is turned into a binary play on Lorcaserin's future, with limits to both gains and losses. If the FDA panel review on May 10 is positive on the drug, the shares will soar, and should go right through the $3.50 level. At that point, the shares you own will be called away at $3.50, handing you a profit of over 21%. Assuming the options are exercised on May 19, that is an annualized return of nearly 370%.

But suppose that the FDA panel is negative on Lorcaserin. If you simply own the stock, it will plunge sharply. Piper Jaffray has openly stated that without Lorcaserin, Arena shares are worth about $1. But in this trade, your $2.50 put provides a clear floor to losses. And since your net cost to acquire the Arena position was $2.88 per share, and you are able to sell those shares at $2.50, your downside is capped at 13.19%. Furthermore, there is a cushion, since you acquired the stock at a net cost of $2.88 per share, versus its present price of $3.06.

Conclusions

There is no such thing as a perfect investment. Every investment has both positive and negative aspects. Here, your losses are capped. But so are your profits. Simply holding Arena Pharmaceuticals stock would allow you to reap the full benefits of its rally on positive FDA action on Lorcaserin. But that also means you hold all the risk of negative FDA action as well. For investors who are more bullish or more bearish on this company, buying or shorting the stock is a wiser proposition. But for investors who like to have clear definitions of their upside and their downside, and have a hedge, this collar trade is a sound idea.

Source: Hedge Arena Pharmaceuticals With An Options Collar