A Low-Risk Dendreon Options Play

Dec.16.07 | About: Dendreon Corporation (DNDN)

Dendreon was back in the news Thursday and shares were up 24% to $6.98 after three members of Congress asked for an investigation into the Food and Drug Administration panel’s vote against approving Provenge. The letter sent to the House Energy and Commerce Committee requesting a probe into the FDA alleges conflicts of interest and ethical violations for at least two FDA advisory committee members who opposed the approval of Provenge.

In March, the FDA advisory panel recommended the approval of Provenge with a 13-4 vote. Then a few months later, instead of approving Provenge, the FDA asked for more patient data. Such a request could delay the drug for years.

The new letter authored by Mike Michaud of Main, points out that the FDA should not have had members of the advisory committee evaluating Provenge who had financial ties to rival companies. A similar allegation was made in an ongoing lawsuit against the FDA filed by the Care to Live group.

Although we don’t know how the Dendreon story will ultimately play out, the new Provenge news created an excellent options trade for those who are even mildly positive on Dendreon’s prospects. On Thursday the January 2009 $2.50 call options (ORGAZ, don’t laugh, this really is the call symbol) closed at $4.55. The January 2009 $5 call options (ORGAA) closed at $4.00. By buying the January 2009 $2.50 calls and selling the January 2009 $5 calls the risk/reward comes in at a healthy 1:4 ratio. For example, buying 10 contracts of ORGAZ and selling 10 contracts of ORGAA results in a maximum gain of $1,950 (exercise gain minus initial spread) and a maximum loss of $550.

For this options strategy to become a four bagger, Dendreon’s stock simply has to finish over $5 by option expiration in January of 2009. This position is also protected down to $3.05, if the stock closed at $3.05 at option expiration this trade would be flat. A stock close anywhere between $3.05 and $5 would result in a positive return for this trade. If Dendreon closes below $2.50 at option expiration the maximum loss (the spread between buying ORGAZ and selling ORGAA) would be realized.

However, the maximum loss is unlikely to be realized for this position even if terrible news comes out for Dendreon. This can be partially explained by taking a look at the Black-Scholes valuation for each of the options in this trade. The January 2009 $2.50 call option (ORGAZ) closed at $4.55 and had a Black-Scholes valuation of $4.40. The January 2009 $5 call option (ORGAA) closed at $4 and had a Black-Scholes valuation of $2.29. Therefore, even if Dendreon announced tomorrow that they are completely giving up on Provenge (a very unlikely announcement); the high priced ORGAA options will lose value faster than the reasonably priced ORGAZ options.

This trade keys on the spread between buying ORGAZ and selling ORGAA. We like this trade with a spread less than $0.65. Yesterday afternoon this trade was available with a spread between $0.40 and $0.75. With a spread less than $0.65 ($0.55 spread used in the above calculations), this trade has an excellent risk/reward ratio. If positive news comes out for Dendreon, the maximum gain will likely be realized.

If the lawsuits and Congressional hearing drag out past January of 2009, then there will likely still be some positive sentiment for Dendreon, and the stock has a good chance of closing over $5 resulting in the maximum gain for this trade. If the stock drops almost 50% by next January to about $3.50, this trade still has a healthy positive return.

At Wall Street Mayhem we really have no idea how the Provenge saga will ultimately play out. However, we think there is a good chance that either positive news comes out or the matter is still unresolved by January of 2009. This trade has a good base risk/reward profile, but risk is further mitigated for this trade by buying the reasonable priced option (from a Black-Scholes perspective) and selling the expensive option.

Suggested Trades:

* Buy DNDN January 2009 $2.50 call options (ORGAZ)

* Sell DNDN January 2009 $5.00 call optoins (ORGAA)

* Conditions: Spread between ORGAZ buy and ORGAA sell should be less than $0.65, DNDN stock should be over $6.50 at time of trade.

Full disclosure: Wall Street Mayhem has a neutral to long position on DNDN options

DNDN 1-yr. chart: