» The Low Risk Trade on Dendreon

The Low Risk Trade on Dendreon

December 14, 2007 on 9:16 am | In Long Term Picks |

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.

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.

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

48 Comments »

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I like the concept, but right now if I pay the spread for each individual option the difference between buying and selling is 80 cents. I’ll keep an eye on it, I really like it at 50 cents or lower.

Comment by Pligg — December 14, 2007 #
I like the trade even though I don’t like DNDN. I think the most probably outcome is that DNDN’s stock finishes 2008 around $3. That being said, I don’t think it will go any lower than that with even a slight chance that Provenge will still be approved, so the trade still looks pretty good to me.

Comment by Trader Joe — December 14, 2007 #
How about just a traditional covered call? If you sell the Jan $5s you have protection all the way down to about $3.

Comment by Larry — December 14, 2007 #
Well, the stock just exploded which appears to have killed the spread between buying and selling. Oh well, I just missed it.

Comment by Mike B — December 14, 2007 #
I like the high short interest in DNDN. I think this short interest should keep DNDN above $5 by next year no matter what happens to the company.

Comment by Krazy — December 14, 2007 #
DNDN is just beginning a surge to double digits. The call sell/buy will be very rewarding if you have the patience to wait.

Comment by tiredowork — December 15, 2007 #
this trade sounds stupid!

Comment by jay — December 15, 2007 #
There are a lot of wild cards that could drive this stock through the roof, not the least of which is the Congressional hearing.
Add in the possibility of EMEA approval, a ROW partner, a hostile takeover, or just plain approval by the FDA to get Congress off its back, and you could have a $10 to $50 share price overnight, making the ORGAZ’s a great play

Comment by Phil — December 15, 2007 #
Will see double digits?? off to the races and could go to $10 or $50 a share?? Do you people even know anything at all about options?? From the calculations above max gain on ten contracts each way is less than $2000 with a cost of about $550. MAX GAIN means that’s the most you’ll get as long as the share price is above $5. Which means it doesn’t matter is DNDN share price is at $5 or $500, you make $2000 on a ten contract spread. Learn something about options before you post dumb comments.

Comment by Matt — December 16, 2007 #
I put on a similar trade but sold dndn $5 puts @ 2.60
and bought $2.50 puts for 55 cents. Additionally, I bought extra $2.50 puts in case dndn gets crushed like GTOP which is now 79 cents.

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