Medivation: Starting to Look Like an Interesting Options Play
The reason for this post is upcoming data for Medivation's dementia drug candidate dimebon from the phase III CONNECTION trial, expected later in the first half of 2010. I want to concentrate on options trading in this post so I won't get too deeply into the background of Medivation and dimebon. For that I'll refer you here - baby biotech journalism just doesn't get any better. I'll add my own personal prejudice - I'm skeptical. Dimebon, or dimebolin, is an antihistamine which has been used in Russia for about 30 years for that purpose. The promising clinical data on which all current dimebon optimism is based was generated in Russia. There is no track record for use of antihistamines to treat dementia and Russia is not the most reliable place in the world. Does that mean that there aren't compelling arguments that the CONNECTION trial will have positive results? Of course not. But as objective biotech investors we should be looking for the best odds of a profit from any binary catalyst.
As a straight forward or short investment, Medivation does not seem promising. Too high risk at the current price for a bet in either direction. Conservative estimates are for a halving or doubling after the results are released, and I believe the actual spread could be significantly larger. The direction of the catalyst itself is a judgement call, without conclusive arguments in either direction by my assessment.
These factors naturally raise interest in options - since the timing of the catalyst is relatively predictable and it seems assured that the magnitude of change in price will certainly be high. Due to the steady appreciation in share price over the last year (more than doubling) without any information to change CONNECTION probabilities, I favor puts. However, I'll look at the options in both directions.
The first issue is timing - the company is holding fast to their original predictions of data in the first half of 2010. But Feuerstein is predicting results in early March based on a report from Bloomberg published just a few days ago. Per Yahoo Finance, puts and calls are available to expire in March and June, although only calls are available with September expiration. I don't know enough about options to know if these are indeed all the available choices, and when others might become tradeable (educate me?). For the sake of argument we'll study those options currently available as per Yahoo Finance.
The second issue is pricing - sometimes it's advisable to choose options close to the stock price as a hedge against unexpectedly low price movement after the catalyst. In this case paying less for options far from the share price might be wiser due to the consensus that the catalyst will almost certainly result in a large shift.
The third issue is hedging with spreads - is it worthwhile to make bets in both directions, counting on the magnitude of the shift to result in a profit regardless of the trial results?
I have to qualify my analysis by admitting that I have very little experience in trading options, nor have I studied the mathematical formulations best used to optimize results. As a general rule, most options trades lose money. I don't even consider options except for rare situations, such as this, where the timing and magnitude of a catalyst seem very well-defined
Now on to the numbers. At the present time, Medivation's share price is 36.5. Here is the cost for the options I plan to evaluate in the format of strike price:ask.
March calls: 35:8.4, 45:5.1 March puts: 35:7, 25:2.65
June calls: 35:14, 45:10.5 June puts: 35:13.1, 25:6.2
It's immediately apparent that the market is well aware of the profit potential from the trial catalyst, and the options contracts are all trading at a significant premium. Again, for the sake of argument assume conservatively that a negative phase III trial will drop the price to 20 and positive results will push the price to 50. Let's model a scenario where we purchase ten 100-option contracts.
March 35 puts will cost us $7000, but the puts will be worth about $15000 with a trial failure. 25 puts would only cost $2650 but would only be worth $5000 with failure. So - risk $7000 for a profit of $8000 or $2650 for a profit of $2350. Seems fairly even. On the other side, March 35 calls will cost us $8400 and will be worth about $15000 (profit $6600) while March 45 calls will cost us $5100 and will be worth about $5000 (no profit). Clearly, attempting to play both sides of the fence is unlikely to be profitable. Adding the prices of the calls and puts would be less than or equal to the value after the catalyst at these post-trial price estimates. Additionally, purchasing March options puts us at severe risk of losing the investment due to expiration prior to the catalyst.
June 35 puts will cost us $13100 and return a profit of $1900 plus whatever time premium remains. 25 puts will cost $6200 and will only return $5000 plus the time premium, essentially break even. June 35 calls will cost $14000 for a profit of $1000 and time premium, and June 45 calls will cost $10500 and result in a loss if the price only goes to 50 with positive trial results.
Ouch. The only trade worth making here would seem to be the March 35 puts for a profit slightly more than the original investment risked, but of course at the risk that the results won't be released until later in the year. However, with a strike price of 35 it seems likely that part or all of the investment could be recovered prior to expiration.
But perhaps I'm being too conservative in estimates of price shift after the catalyst. Let's try once more with a price of 15 after a negative result and 60 with a positive result. March 35 puts will cost $7000 and be worth $20000 ($13000 profit). March 25 puts will cost $2650 and be worth $10000 ($7350 profit). March 35 calls will cost $8400 and be worth $25000 ($16600 profit) and March 45 calls will cost $5100 and be worth $15000 ($9900 profit). Once again playing both sides simultaneously would be barely profitable and clearly not worth the risk of getting washed due to results after options expiration. June 35 puts will cost $13100 and return a $6900 profit while June 25 puts will cost $6200 for a profit of $3800 (plus time premiums). June 35 calls will cost $14000 and give us a profit of $11000 while June 45 calls will cost $10500 and profit $4500 (all plus time premiums).
Are you still with me here? That makes two of us left. Overall the puts seem somewhat cheaper and more likely to result in a profit by my analysis, and that assumes equal likelihood of positive and negative trial results. If you're a skeptic, like me, that skews the judgement even further in the puts direction. Since we've eliminated options spreads as unlikely to be profitable, the only trade left to consider is puts. One possibility would be to purchase March 35 puts and June 25 puts, hedging against a late data release. But I think given the recent upward trend in the share price I'm going to see if I can pick up these expensive options later in the month at lower prices.