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Arena Pharmaceuticals, Inc. (ARNA): Covering The FDA's Call

 June 25, 2012 01:17 PM
 


(By Rich Bieglmeier) The US Supreme Court's Obamacare decision this week isn't the only big news due from the health care sector. As we wrote on May 15th in Investors To Get Fat Profits From Obesity Drugs, Arena Pharmaceuticals, Inc. (ARNA) should hear from the FDA regarding their obesity drug, Lorcaserin, by Wednesday's close.

When we last wrote about ARNA, the stock was trading at $6.54, at the moment the biotech is trading slightly lower than $10. In our Getting Fat article, we said, "ARNA's stock is worth at least $9.68 on approval."

[Related -Stocks Jump 1 Pct On Strong Jobs Data; AIG Gains]

So much for that, ARNA is worth more on anticipation. In fact, the stock touched $11.99 since mid-May.  Approval is likely to put $11.99 in the rearview mirror and a setback, probably cuts the stock in half – risk is running high.

Apparently, the possibility of losing big didn't scare off investors last week. Using our proprietary accumulation/distribution model, traders accumulated more than 5% of the company's market cap. Wall Street poured nearly $100 million into ARNA during the week leading up to the FDA's decision. Clearly, the Street is banking on good news.

Unlike the prop desks on Wall Street, most investors are unwilling to accept the risk of losing half of their investment on the whim of a regulatory body. For those of you who bought Arena shares a month ago, you might consider writing some covered calls as insurance.

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The most recent trade for the July 10 call option is $2.12. Shareholders with big profits might consider writing one call for every 200 shares of ARNA, or if you are ok with selling the stock at an equivalent of $12.12 per share, go one covered call per 100 shares.

The way covered calls works goes like this, somebody buys the right to buy ARNA from you at $10, but is willing to pay $2.12 per contract for that right. That translates to $212 for every 100 shares, or a premium of 21.5% form the potential blockbuster's current price.

If the stock closes above $10 on options expiration date, then your shares will be sold for $10, but you get to keep the $212 per 100 shares in your discount broker's account. So, if you own 1000 shares, and executed the one-for-one suggestion, your account would be credited with $2,120. A credit of $1,060 would post using the one call for 200 shares scenario.

On approval, the one for one writers are likely to lose their stock, but at a cost of $12.12 – if you bought based on the May 15th article, that's nearly 100% in a little more than a month – not too bad for the price of the advice.

Now, if you want to keep some of the upside of approval, then the one for every 200 shares makes more sense. Half of your stock will go to the option buyer at $10 and, again, you get to keep the call option premium.

In the event the company fails to win the FDA's OK, then you have lowered your cost average by more than two bucks, thereby reducing your losses, maybe even maintaining a small profit on a rejection.

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