Trading Covered Calls In The Pharmaceutical Sector

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 |  Includes: AMRN, ARNA, VVUS
by: David Sims

As of the close of the market on Friday, three lucrative covered call opportunities existed in three Pharmaceutical companies, Amarin Corporation plc (NASDAQ:AMRN), VIVUS Inc. (NASDAQ:VVUS), and Arena Pharmaceuticals, Inc. (NASDAQ:ARNA).

Do your own due diligence before investing, but here I will outline each trade using a simple online covered call calculator provided by the Options Industry Council.

Amarin Corporation plc

Amarin stock has a $2 billion market capitalization, trades at a large forward P/E ratio, and has negative book value per share. This is not what most people would consider a blue chip stock. There is a potential to make large profits or large losses trading in a company like this. Most of the value is derived from intellectual property.

Still, the stock is trading above the 50-Day moving average, and a covered call could reduce downside risk, if there is reason to sell.

Amarin 1-Year Chart, 50-Day SMA (click to enlarge)Click to enlarge

The covered call trade for this stock involves a simple sale of an in-the-money call with a $15 strike price, producing a premium of $1.25. The sale of the call is made against shares purchased at the current market price of $15.12. Assuming a modest level of commissions, your profit will be reduced to 6.6% return, as long as the shares trade above $15 at expiration in 14 days (July 21, 2012).

The break-even price on the trade is $14.07, which means the stock would need to fall below $14.07 before you record a loss.

(click to enlarge)Click to enlarge

VIVUS Inc.

VVUS stock has a $2.8 billion market capitalization, trades at a large forward P/E ratio, and has about $3 book value per share. The company has a blockbuster weight loss drug called Qnexa that is seeking FDA approval on or before July 17th. The tremendous option premium is likely a result of speculation that the drug will be a game-changer for the company.

VVUS 1-Year Chart, 50-Day SMA

Click to enlarge

The simple covered call trade involves buying the stock at the current market price of $28.51 and selling in-the-money call options with a strike price of $26 for a premium of $4.90. The expiration date is July 21, 2012. Factoring in moderate commissions, the return potential over 14 days is 9.2%. Annualized, this is a 236% return.

The break-even price for the trade is $23.81, meaning that the stock would need to fall below this price before any loss is recorded. This is 16.5% below the current market price.

(click to enlarge)Click to enlarge

In this type of situation, the risk is that the FDA will disappoint investors by blocking the drug. There is also the risk of a sell-off after good news is announced. Still, the stock chart shows an upward trend and the expiration date for the covered call trade is 14 days away. If the stock falls precipitously, an investor may be able to sell the stock shares before reaching the break-even price for the trade.

Arena Pharmaceuticals, Inc.

Arena also has about a $2 billion market capitalization and shares many of the same characteristics as the other two companies. Unlike VVUS, Arena's weight loss drug, Belviq, has already been approved by the FDA.

The 1-Year chart tells a strong story over the past year, with the stock trading above the 50-day moving average and trending up.

ARNA 1-Year Chart, 50-Day SMA Click to enlarge

The covered call trade for this stock involves buying shares at the price of $11.11 and selling an in-the-money call option with an $11 strike price, for a premium of $0.93. The option expiration is July 21, 2012. Factoring in modest commissions, the return potential for the trade is limited to about 6%, but over 14 days, that's an annualized return of 153.6%.

The break-even price for the trade is $10.38. Below this stock price, the trade begins to lose money.

(click to enlarge)Click to enlarge

The covered call trade on Arena may have lower risk than the trade for VVUS or Amarin, as they just received FDA approval. This is also reflected in the lower return potential for the covered call transaction.

Covered calls have risks similar to owning stocks outright. If a catastrophic event occurs, the stock price could fall precipitously. You still own shares in the company, and will see those shares fall, just like owning shares outright. Selling call options against your shares actually reduces your investment risk, as it returns a portion of your money at risk. However, by selling the call option, you also limit the potential return on the investment.

The benefit to a stock investor is that discipline is added to trading the stock. By selling the call, you are locking in a sales price and creating an exit strategy that should generate a profit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.