FDA Advisory Committee/Panel dates often provide interesting trading opportunities with very favorable risk/reward characteristics due to the extreme levels of implied volatility. The scheduled July 15 Vivus (Ticker: VVUS) Advisory Committee for its obesity drug Qnxa is no exception(1): on the day of the announcement of the Advisory Committee date, implied volatility immediately jumped by over 100%. Options currently suggest an up/down move of over $7.00 per share.
I am taking advantage of the elevated levels of implied volatility by structuring a multi-leg option position. Here is the initial trade based on 30 contract option position with VVUS trading around $12.00~12.50 during trade-in(s) and implied vol in the 200~230% range:
SELL 30 July 11.0 Strike CALL @ 4.30 ($12,900 Credit*)
SELL 30 July 13.0 Strike PUT @ 4.00 ($12,000 Credit)
BUY 30 July 17.5 Strike CALL @ 1.60 ($4,800 Debit)
Total Credit: ($24,900)
Total Debt: $4,800
Net P&L: ($20,100)
*For the uninitiated: DEBIT means you pay cash; CREDIT means you get cash.
This trade makes money as long as VVUS is above ~$6.30 by expiration (July 17, 2010). Maximum profit of $14,000, based on this initial trade size, is achieved between $11 and $13. Profit declines to the $17.50 Strike where it remains at approximately $600 for all higher share price amounts. Below I provide a P&L chart to depict the concept of the payout at expiration. This strategy seeks to profit from a slight to moderate increase in the share price from current levels and a total collapse in implied volatility. This is a neutral trade with a bullish bias. Of course other types of trades can be structured (i.e. highly bullish or highly bearish), but this structure, in my opinion, appears to have the best risk/reward characteristics for this particular situation within the expiration timeline.
In this trade (as in all trades) it is very important to assess the risk should there be a negative outcome. Advisory Committees are legendary for unexpected outcomes so risk needs to be fully understood. This trade structure begins to lose money at $6.30, an approximate 50% drop from current levels. This theoretical downside scenario implies a very negative Advisory Committee. Based on existing data, this scenario seems unlikely. According to the Company, Qnexa achieved “unprecedented weight loss of 14.7%, a decrease in blood pressure for all patients including hypertensive patients, improvements in lipids levels including hypertriglycerdemics and all three doses of Qnexa exceeded FDA efficacy benchmarks”(2) suggesting the potential for a favorable Committee review. In order to vet the risk side of the trade, however, I assume that the Advisory Committee is negative (the downside is the only risk in this structure). In such a scenario, what price would VVUS trade? Taking this concept to an extreme, if VVUS is immediately liquidated and all of its drug development programs and IP assets are valued at zero, the shares would be valued at approximately $2.16(3). This basically represents net cash per share, a floor value. This is an unlikely near term outcome no matter how bearish a trader is with VVUS. VVUS maintains a strong IP position, several additional Phase 2 candidates, and another Phase 3 candidate (Avanfil) with approaching catalyst event(s) (more results expected in 2010)(4). As mentioned above, options are implying an up/down move of around $7. On a downside basis, this implies an initial move down to $5 a share, which seems about right, based on fundamental data, for a negative outcome scenario.
If VVUS trades down to $5 following the Advisory Committee, there are two primary routes to manage this (painful) situation. One option is to simply close out the entire position (at a loss). A better approach, however, may be to take assignment of the shares (remember part of the structure was selling the July 13 Strike PUT; in this example, since the PUT are in the money at expiration, I am assigned the VVUS shares). My cost in the shares would be around $6.30 (within the context of the example, the shares are at $5.00; hence a loss of $1.30 a share has thus already been incurred according to the scenario). This approach may be better because I end up holding shares in a Company with several additional near term catalyst events. In this scenario, I maintain the potential upside from both the PDUFA date in October (which may produce an upside surprise following this theoretical downside scenario) and the potential upside from the Avanfil follow-on catalyst event(s). If I wish to recapture my losses and/or lower my cost of the trade I also maintain an option to sell CALL against the share position. Making several assumptions(5), DEC 5 CALL premium should be trading around 1.00/1.30 following a failed Advisory Committee event. Selling this premium against my share position (i.e. covered CALL), and assuming no further share declines (a big assumption?), my “downside” P&L would therefore be near/at zero on the entire trade(6) if the shares trade above $5 at expiration. If the shares don’t trade above $5 at expiration, my cost of trade declines below $5 a share and I still retain the option to hold the shares or sell even more CALL against the position(7).
(1) Back in March, VVUS announced that the FDA accepted the Company’s NDA for its obesity drug Qnexa. The Company recently reported that it is scheduled to face the FDA Advisory Committee on July 15, 2010 to review the NDA. A PDUFA date of October 28, 2010 has been set by the FDA.
(2) Source: Company Presentation, Rodman & Renshaw Annual Global Investment Conference, May 18, 2010.
(3) $2.16 per share = net cash of $174.94mln divided by fully diluted shares outstanding of 80.698mln. Source: 1Q’10 SEC 10-Q. As of March 31, 2010.
(4) Source: Company Presentation, Rodman & Renshaw Annual Global Investment Conference, May 18, 2010.
(5) To calculate the estimated CALL option premium in this example, I assume a post-Advisory Committee implied volatility of 80% to 100% and a share price of $5 as of July 19, 2010, the date of the theoretical trade.
(6) Make no mistake: selling the CALL against the position in this example is a damage control strategy on a failed trade. Usually in this situation the best route is to simply take the initial loss and get out.
(7) It should be noted, however, that CALL premiums in such a scenario will be at significantly lower values.
Disclosure: Long and Short Calls, Short Puts