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Κύρια The Biotech Trader Handbook (2nd Edition)
The Biotech Trader Handbook (2nd Edition)T. Ayers Pelz
Small cap biotech companies spend hundreds of millions of dollars and over ten years moving experimental drug candidates from concept to fully approved drugs. For late stage drug candidates, those in Phase III, positive or negative data can result in either massive gains or devastating declines in the sponsoring company's stock price. This "ultimate catalyst event" provides smart, organized & nimble option traders spectacular & consistent trading opportunities. In this unique book, the author provides individuals unfamiliar with the world of small cap biotech a fast, simplified and efficient approach to identify, analyze & execute trading strategies using options. The following topics, amongst others, are covered in this book: * Description of the FDA drug trial process, from pre-clinical to Phase III & beyond * Identification, categorization & organization of small cap biotech companies * Structured & streamlined approach to assess small cap biotech companies * Notes on trading strategy & tactics * Detailed description of option trading structures best suited for small cap biotech This book is an absolute "must have" for individuals thinking about trading in the fast paced and often confusing world of small cap biotech.
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Copyright © 2011 T. Ayers Pelz ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any other means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher and the author. This book is sold with the understanding that neither the author nor the publisher is engaged in rendering financial, investment, legal or accounting or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book. There is a substantial risk in trading options and it is not suitable for everyone. ISBN: 1-450-59853-6 E-Book ISBN: 978-1-4392-7891-8 EAN-13: 9781450598538 Printed in the United States of America. Cover design and book layout by Marni Mitchell. ACKNOWLEDGEMENTS To Thomas, my little office assistant and future option trader To Bill and Lynn, your support is always appreciated To Billy V., for getting me interested in investing To Marni, for your design work and advice And Most of All to My Wife Pilar, for convincing me to write this book CONTENTS TITLE PAGE COPYRIGHT PAGE PREFACE PART I 1.0 BACKGROUND 1.1 THE FDA CLINICAL TRIAL PROCESS 1.2 TRADING THESIS & BOOK FOCUS 2.0 TRADE CANDIDATE IDENTIFICATION 2.1 OVERVIEW 2.2 SMALL CAP BIOTECH TRADER TOOLS 2.2.1 FDA & CLINICAL TRIAL CALENDAR 2.2.2 TWITTER ACCOUNT 2.2.3 ON-LINE RESOURCES 2.3 COMPREHENSIVE INDUSTRY SEARCH 2.3.1 OVERVIEW 2.3.2 TRADE CANDIDATE TICKER LIST 2.3.3 ORGANIZATION STRATEGY 3.0 TRADE CANDIDATE ANALYSIS 3.1 FAST REVIEW STRUCTURE OVERVIEW 3.2 CASH PROFILE 3.2.1 OVERVIEW 3.2.2 CASH BURN 3.2.3 CASH PER SHARE 3.2.4 NET CASH / NET DEBT BALANCES 3.2.5 SOURCES OF CASH 3.3 OWNERSHIP 3.4 INSIDER ACTIVITY 3.5 ANALYST VIEW 3.6 TECHNICAL ANALYSIS 3.7 PIPELINE 3.8 INDUSTRY SUPPORT 3.9 CONCLUSION 4.0 OPTION BASICS 4.1 OVERVIEW 4.2 CONCEPTUAL FRAMEWORK 4.2.1 OPTION BUYER VERSUS OPTION SELLER 4.2.2 THE OPTION CHAIN 4.2.3 THE IMPORTANCE OF UNDERSTANDING THE BID / ASK SPREAD 4.2.4 VOLUME AND OPEN INTEREST 4.2.5 OPTION EXPIRATION 4.2.6 INTRINSIC AND EXTRINSIC VALUE 4.2.7 “MONEYNESS” 4.2.8 TIME AND OPTIONS 4.3 THE FOUR FUNDAMENTAL OPTION POSITIONS 4.3.1 PUT BUYER 4.3.2 PUT SELLER 4.3.3 CALL BUYER 4.3.4 CALL SELLER 4.4 BASIC OPTION VALUATION 4.4.1 CALCULATING THEORETICAL VALUE 4.4.2 (NON-TECHNICAL) OVERVIEW OF THE GREEKS PART II 5.0 TRADING STRATEGY & TACTICS 5.1 OVERVIEW 5.2 PRE-TRADE ASSESSMENT 5.3 NO OPTIONS? NO STRIKES? NO PROBLEM 5.4 “LEGGING” IN 5.5 BUILD POSITIONS IN SMALL BLOCKS 5.6 NEVER TRADE AT THE BID OR ASK 5.7 ESTIMATING PRICE MOVEMENT 5.8 SCENARIO TESTING 5.9 TAKE-OFF YOUR STOPS 5.10 (VERY) HIGH SHORT INTEREST = DANGER 5.11 MONITOR OPTION ACTIVITY PRE-CATALYST 5.12 EXIT OR HOLD PRE-CATALYST? 5.13 EXIT POST-CATALYST? 5.14 GETTING OUT OF ILLIQUID (LONG) OPTION POSITIONS 5.15 ESTIMATING PRICE ON FAILURE 5.16 THE SALVAGE VALUE STRATEGY 5.17 TRADING ADVISORY PANELS 6.0 TRADE STRUCTURES 6.1 OVERVIEW 6.2 TRADE STRUCTURE REVIEW PRIMER 6.3 TRADE STRUCTURES 6.3.1 LEVERAGED CALL (UN-HEDGED) 6.3.2 LEVERAGED CALL (HEDGED) 6.3.3 (LONG) CALL AND PUT SPREADS 6.3.4 LOW COST / NO COST BUTTERFLY 6.3.5 “ONE-WINGED” BUTTERFLY 6.3.6 “ONE-WINGED” BUTTERFLY – TIME VARIANT 6.3.7 “SHORT STRIKE” IRON BUTTERFLY 6.3.8 TIME SPREAD (POSITION BUILD) 6.3.9 HEDGED TIME SPREAD 6.3.10 LONG TERM PUT SALE 6.3.11 EXTREME VOLATILITY COVERED CALL 6.3.12 SHORT STRADDLE 6.3.13 SHORT STRANGLE 6.3.14 “SPLIT MONTH” SPREAD 6.3.15 “THE BOX” 6.4 A FEW NOTES ABOUT PHASE I/II TRADES 6.4.1 PUT SALE PRE-ANNOUNCEMENT 6.4.2 SHORT SHARES POST-POSITIVE PHASE I/II ANNOUNCEMENT 6.4.3 LONG-TERM STOCK ACCUMULATION 6.5 TRADE STRUCTURES NOT RECOMMENDED 6.5.1 NAKED PUT / CALL SALE (AT CERTAIN PRICES) 6.5.2 STRAIGHT PUT / CALL BUY 6.5.3 STRADDLE / STRANGLE BUY 6.5.4 COVERED CALL (ABOVE CERTAIN PRICES) 7.0 TRADE PROCESS 7.1 OVERVIEW 7.2 DEVISING A TRADE: THE PROCESS 7.2.1 DEFINE RISK CAPITAL & RISK STRUCTURE 7.2.2 ESTABLISH TIME, VALUE & VOLATILITY BOUNDARIES 7.2.3 DETERMINE LOGIC BASED CONVICTION 7.2.4 OPTION CHAIN SCAN 7.3 EXAMPLE TRADES 7.3.1 TRADE #1 7.3.2 TRADE #2 DRUG TRIAL & FDA GLOSSARY EXHIBITS 2.1 FDA & CLINICAL TRIAL CALENDAR ON-LINE RESOURCES 2.2 WEBSITES FOR BIOTECH TRADERS 2.3 TRADE CANDIDATE TICKER LIST 3.1 FAST REVIEW STRUCTURE COMPONENTS 3.2 ACADIA 2Q’09 CASH PROFILE 3.3 ACADIA 2Q’09 FINANCIALS 3.4 SECONDARY OFFERING BY SPECTRUM 3.5 SUMMARY COMPENSATION FOR MANNKIND CORP. 3.6 BASIC QUESTIONS REGARDING INSIDER TRANSACTIONS 3.7 FORM 4, SECTIONS 1 AND 2 3.8 FORM 4, SECTION 3 AND NOTES 3.9 FORM 4 TRANSACTION CODES 3.10 XYZ CORPORATION PIPELINE 3.11 ABC PHARMACEUTICALS PIPELINE 4.1 KEY OPTION TERMS 4.2 OPTION CHAIN FOR ABC STOCK 4.3 OPTION CHAIN FOR XYZ STOCK 4.4 INITIAL P&L IMPACT OF BID / ASK SPREAD 4.5 OPEN INTEREST AND VOLUME 4.6 SEPTEMBER 2010 AND JANUARY 2011 SERIES 4.7 OPTION CHAIN FOR EFG STOCK 4.8 IMPACT OF TIME ON OPTIONS 4.9 OPTION CHAIN FOR QRS STOCK 4.10 PUT BUYER P&L DIAGRAM (AT EXPIRATION) 4.11 PUT SELLER P&L DIAGRAM (AT EXPIRATION) 4.12 CALL BUYER P&L DIAGRAM (AT EXPIRATION) 4.13 CALL SELLER P&L DIAGRAM (AT EXPIRATION) 4.14 CALCULATING XYZ 5.0 CALL THEORETICAL VALUE 4.15 XYZ VOLATILITY DATA CHART 4.16 POSITIVE AND NEGATIVE GAMMA 4.17 THETA IMPACT ON OPTION PREMIUM 4.18 GRAPHICAL DEPICTION OF IMPACT OF THETA OVER TIME 5.1 WHEN TO AVOID TRADING ILLIQUID OPTIONS 5.2 XYZ CALL OPTION QUOTES 5.3 SCENARIO A—INCREASE BY $1 5.4 SCENARIO B—DECREASE BY $1 5.5 IMPLIED VOLATILITY PRE-CATALYST EVENT 5.6 MONITORING NET CHANGES IN OPEN INTEREST 6.1 LIST OF CONDITIONS 6.2 EXAMPLE OF TRADE CONSTRUCT NOTATION 6.3 SPREADSHEET POSITION TRACKER FOR BUTTERFLY 7.1 TRADE #1 BOUNDARY DATA 7.2 TRADE #1 BOUNDARY DIAGRAM 7.3 OPTION CHAIN FOR XYZ STOCK 7.4 TRADE #2 BOUNDARY DATA 7.5 TRADE #2 BOUNDARY DIAGRAM 7.6 OPTION CHAIN FOR ABC STOCK PREFACE Let me introduce myself. I am not a biotech expert nor do I have any background, professional or academic, in science. I basically know very little (if anything) with regards to the science behind drug development in the biotech industry. I am a former trader with a large, global bank’s proprietary trading desk (i.e. a “prop trader”) based in Europe. I was responsible for a portfolio with book limits of over $200 million. My team traded everything from futures, forex, options, credit default swaps, variance swaps, convertible bonds, straight bonds, bank loans, preferred stock, hybrids and common stock – you get the idea. I learned to trade from the institutional side (i.e. professional side). The skills I developed from this experience were invaluable. Before prop trading, I was an M&A, corporate finance and credit banker in the U.S., Latin America, Asia and Europe for over 10 years – with regards to analyzing companies, I can tear apart the financial statements and tell you just about everything you would want to know about the financial health of a company in about an hour – stripes I earned from the continued brutal 130 hour work weeks. That’s about all I will say regarding my professional background. In 2008, I accepted a severance package from my bank. Rather than scrounge for work and publicly flog myself on LinkedIn, I decided to pursue my true passion: option trading. So I set-up a company using my hard earned savings, and started to trade options for my own account. As you may be aware, and as I quickly realized, trading for a living is a complete different lifestyle then having a salary with a big bonus at the end of year. This is an “eat what you kill” business and requires constant and aggressive diligence. I need to actively and constantly find new ways to make money on a daily basis. The specter of running out of money was (is) a constant (and terrifying) thought. When assessing the universe of potential trading strategies to make my daily wage, I came across biotech, of which I had some prior experience trading. What has always intrigued me about biotech, especially within the volatile market that characterized 2007 ~ 2009, was its market neutral aspect – the market could be tanking and certain biotech stocks would either not move or they would go up. Others would get absolutely slaughtered. Those companies with near to medium term catalysts traded almost completely independent from the rest of the market. Another, and more important aspect, especially from the perspective of an option trader, was the “defined event” aspect – drug candidate announcement dates are announced in advance – at times, the exact date of an announcement is given. This is different than for instance, an earnings announcement. In this case, the biotech company’s entire future could be at stake. Fortunes could be made or lost in the blink of an eye, literally – hence huge price movements will, with near absolute certainty, be made. This creates a dream scenario for smart, organized and nimble option traders who are able to identify these names well in advance. Even when one arrives late to the event (i.e. a FDA or clinical trial catalyst event), with the versatility afforded by using options, there are other styles of trades one can execute to profit handsomely. I became very excited – I immediately knew this would generate some decent upside and become a core element, amongst many elements, of my overall trading strategy. So I naively set about to study every possible aspect of “biotech.” I read books (most published more than 10 years ago and therefore of limited use) and articles on the internet, I studied university textbooks, read magazines, etc. I even considered taking biochemistry classes at a local university. After several weeks of intense study, I realized and accepted that I would never be able to understand the underlying science of each company’s drug candidate(s). I know now, however, that having this specific, deep knowledge is actually not necessary (although it would be nice). Drug trials are tricky – even with a PhD in the underlying science, an outsider will never know, with certainty, if the FDA decision or clinical trial will turn out to be positive or negative given all of the variables involved (if one could, they would be the richest person alive). If someone tells you or claims their knowledge in the subject qualifies them to more accurately assess the outcome of a catalyst event, they are lying or selfdelusional. Perhaps they will understand the results once announced as being negative or positive but this is irrelevant as the market will immediately assess the value for you post-announcement (as evidenced by the movement in the share price). Perhaps they will argue, for example, that they can better assess the structure of a trial (and therefore the likelihood for positive or negative results) – even then, they still cannot ascertain whether or not the trial will be successful. Forget about it – as far as I am concerned, the playing field is flat with regards to this element. I realized this presented a huge opportunity. With this in mind, over the next six months, I developed and honed a fast, simplified and efficient process to assess opportunity in biotech. Using this streamlined construct, my goal was to assess every listed biotech company meeting specific criteria as fast as possible. Yes, that meant hundreds of companies – I didn’t care. Following the assessment, I would either initiate a trade or not. That was the plan. My hard work paid off. In the first six months, I generated hundreds of thousands of dollars in profits trading both successful and unsuccessful FDA and clinical trial catalysts. This may not seem like much, but in order to generate these returns, I risked less than $25,000 in total. Yeah, that’s right, less than $25,000. I could have potentially generated over $1,000,000 but I value risk-adjusted returns over straight out gambling that I (and you should) refuse to do. I made this money using “smart,” opportunity-specific strategies: leveraged calls (risk reversals), combinations of Puts and Calls (short and long), vertical spreads, butterflies, hedged short straddles/strangles, playing the explosion/collapse in volatility, extreme (i.e. + 350%) high volatility strategies, you name it – every opportunity and associated trade structure played off of the individual strengths and weaknesses of the company and the situation. This book’s main purpose is to provide individuals with some knowledge of options a simple and efficient way to get involved in the world of biotech as fast as possible. Using my techniques and methodologies, any reader of this book who understands options, with the proper analysis and trade construct, in addition to a good sense of work ethic, can potentially achieve solid results. I obviously cannot guarantee that you will profit from this knowledge, nor should you infer otherwise, but using these strategies and techniques may accelerate your ability to actively trade, in a knowledgeable manner, in these situations. Good luck to you. Tony Pelz Denver, January 2011 “…THIS IS THE LESSON. NEVER GIVE IN. NEVER, NEVER, NEVER, NEVER – IN NOTHING, GREAT OR SMALL, LARGE OR PETTY – NEVER GIVE IN…” WINSTON CHURCHILL OCTOBER 29, 1941 PART I CHAPTER 1.0 BACKGROUND 1.1 THE FDA CLINICAL TRIAL PROCESS Overview First off, it is essential to gain a basic understanding of the drug development process within the context of the Food and Drug Administration (“FDA”) clinical trial structure as it provides the basis for the entire trading strategy presented in this book. In order to bring a drug candidate from concept to an approved and marketed drug, a sponsoring company needs to move the drug candidate through a series of “trials,” coordinating with and seeking approval from the FDA at nearly each step. These trials are broadly divided into three phases (after Pre-Clinical studies). There is no need for fifty pages on this subject – the essential elements of each step of the overall drug development process are ordered numerically and listed below1 : (1) Pre-Clinical The Pre-Clinical phase involves researching and testing new drug candidates in the laboratory and on animals. The primary goal of the Pre-Clinical phase, amongst others, is to determine if the identified drug candidate is safe on humans. The Pre-Clinical phase can take from 3 to 5 years (and possibly longer) to complete. (2) File IND with FDA Drug candidates that show very promising results in Pre-Clinical studies may be moved to Phase I by filing an IND (“Investigational New Drug Application”) with the FDA and receiving their approval. An IND essentially seeks FDA approval to allow the company to initiate the testing of the drug on humans. The IND also, amongst other elements, includes detailed information on the structure of the trials the company intends to use for testing the drug. (3) Phase I In Phase I trials, researchers test the experimental drug candidate in a small group of people (20 - 80) for the first time to evaluate its safety, determine a safe dosage range, and identify side effects. Phase I can take up to 1 year. There is no guarantee the experimental drug or treatment will move to Phase II. (4) Phase II Assuming positive results are achieved in Phase I, the drug candidate may move to Phase II. In Phase II trials, the experimental drug candidate is given to a larger group of people (100 - 300) to see if it is effective (efficacy) and to further evaluate its safety. Phase II can take from 1 to 2 years. The company must seek FDA approval to proceed to Phase III. Following a successful Phase II, a company often, although not always, seeks a Special Protocol Assessment (“SPA”) from the FDA. This is a declaration by the FDA that the up-and-coming Phase III trial’s design, clinical endpoints and other trial elements, if met, will be acceptable for an FDA approval. This may enhance the likelihood of FDA approval upon successful Phase III data. (5) Phase III In Phase III trials, the experimental drug candidate is given to large groups of people (1,000 - 3,000) to confirm its effectiveness, monitor side effects, compare it to commonly used treatments, and collect information that will allow the experimental drug or treatment to be used safely. Phase III can take from 1 – 4 years. The company will file an NDA (“New Drug Application” or BLA, “Biologics License Application”2) with the FDA with positive Phase III results. (6) File NDA with FDA Prior to marketing the drug candidate, the company must file an NDA with the FDA. This proposal seeks to gain the FDA’s approval of the new drug for sale in the U.S. The application must provide sufficient evidence for the FDA to decide that the drug is safe and effective and that all other FDA criteria are met. Applications often run hundreds of thousands of pages long and include all information from not only every clinical trial but also pre-clinical data. It should be noted at this juncture that a positive Phase III does not guarantee an ultimate approval of the drug candidate – the FDA first needs to review all data. The FDA has 60 days to accept the NDA or reject it (due to it being incomplete). If the NDA is rejected the company will rectify the deficiencies and resubmit. (7) FDA Review It can take around 1 to 2 years for the FDA to fully review an NDA. You will often see references to a PDUFA date. PDUFA (“The Prescription Drug User Fee Act”)3 was created to help shorten the lengthy NDA review time. The act allows the FDA to collect user fees from pharmaceutical companies in order to expedite the review. The act specifies that the FDA review drug applications from six to twelve months depending upon the nature of the drug. For example, a drug candidate that targets a disease where there is currently no treatment will have a higher priority than a drug with many competing treatments. The PDUFA date is the approximate date when the FDA will render a decision with regards to the NDA.4 During the review, the FDA assesses the drug candidate’s safety and effectiveness. The FDA also reviews the proposed labeling for the drug and inspects the facilities where the drug is to be manufactured. During the review process, the FDA may also convene an “Advisory Panel” (or Advisory Committee) to further review the drug candidate. An Advisory Panel is a single day meeting where independent industry experts review and opine on a drug candidate’s data presented by the company and FDA reviewers. At the end of the meeting a vote is taken by the committee to decide whether or not to approve the drug and under what conditions, if any. A positive committee vote normally bodes very well for the company’s drug candidate whereas a negative vote can be quite damaging for the drug candidate’s prospects. It is important to note that the FDA is not required to follow the recommendations of the Committee (but usually does). Advisory Panels present interesting trading opportunities – this will be discussed in Section 5.17. Once the FDA’s review is complete, the NDA will be approved or rejected. If the drug candidate is rejected, the FDA issues a “Complete Response Letter” or CRL, which provides the sponsoring company a rationale for the rejection and what data, if any, could be provided to make the application acceptable. Often, the FDA may require additional trials – this can take several additional years and can be devastating to the company. The FDA often makes a tentative approval requesting that a minor deficiency or other issue be corrected before an approval is granted. If the drug candidate is approved, the company can then bring the drug to market. Conclusion The key point to understand about the trial construct is that the drug development process can take well over 10 years before it produces a marketable drug that can generate revenues for the sponsoring company. During the entire process, the developing company will invest significant financial resources, which it may or may not have or may need to raise, to move each candidate through each phase. It has been estimated that moving a drug from discovery, through each trial phase and ultimately to the market costs well over $800 million.5 At each phase, the probability of failure is extremely high. For every 5,000 to 10,000 compounds that enter pre-clinical testing, one is approved for marketing.6 A failed drug candidate can prove fatal to an emerging biotech company. 1.2 TRADING THESIS & BOOK FOCUS The primary focus of this book, and the basis for the trading strategies described herein, is to focus on (a) small cap biotech companies (b) with one or more Phase III drug candidate(s) where result announcements or catalyst events are due under a year and a half7 and (c) where the company has listed options. These three elements combined create unusual catalyst events that contribute to spectacular trading opportunities with near absolute certainty. Companies with Phase III Candidates First of all, as described above, Phase III clinical trial and FDA related events are the ultimate stock moving catalysts, either negative or positive, for the small cap biotech company. In this case, and depending upon each individual company’s situation, the impact on the share price can and usually will be substantial – as traders, this is exactly where we want to be. Focusing on companies whose leading drug candidate is in Phase I or Phase II normally lacks this key catalyst event. If you are an “investor,” and you buy the common stock (or worse, the options) of one of these companies (Phase I/II), then fine – just realize you will be holding the shares for well over 5 years, at least, you will get no dividends, your company will likely continue to face financial challenges as you face multiple dilutive events as the company raises funds to continue trials (oh, and by the way, the out of the money options you purchased will likely turn out to be worthless). At the end of the line, the entire company could go bankrupt on a failed clinical trial or FDA event. Your patience will have been for naught.8 Focusing on a company with a Phase III event within under a year and half, will allow you to fast forward to the ultimate catalyst event. Companies with Options Where possible, your focus should be on companies where you can trade options. Obviously this is not possible on most developing small cap biotech companies, but your focus should be on these companies, nevertheless. The (obvious) rational is that there is more flexibility with regards to the trade structure. When only the common stock can be traded, you can either buy or, where possible, short. With options, the trade structure can be tailored to fit the event and is virtually unlimited. In addition, the trade structure can be adjusted during the trade to fit new issues which eventually come up over the period of the trade. In the chapter on Trade Structures, we will review these strategies in detail. Structure of this Book This book is structured into six key chapters: Trade Candidate Identification: This chapter quickly reviews how to find small cap biotech companies, provides a list of biotech related internet resources, lists small cap biotech tickers and provides some advice on developing a company database. Trade Candidate Analysis: This chapter provides a structured, simplified and efficient approach to analyzing small cap biotech companies as fast as possible. The review process covers analysis of small cap biotech company cash profile, ownership structure, insider activity, analysts views, technical analysis, pipeline and industry support. Option Basics: This chapter reviews options from a trading perspective. The primary goal is to provide the reader a conceptual understanding of how options work and how they can be used to make money. Trading Strategy & Tactics: This chapter covers several trading techniques, strategies and tactics when trading both illiquid option markets and small cap biotech companies. Trade Structures: This chapter details selected trading structures appropriate for small cap biotech. This chapter also reviews notes regarding trading companies with only Phase I and II candidates and discusses trading structures that are not recommended. Trade Process: This chapter describers a process to follow when there is no initial bullish, bearish or neutral trade conviction (as is often the situation when trading FDA and clinical trial catalysts). Several trade examples are provided at the end of the chapter. CHAPTER 2.0 TRADE CANDIDATE IDENTIFICATION 2.1 OVERVIEW The first step in the trade process is the identification of a good universe of trade candidates. This process can be approached passively (where specific ideas are generated from external sources) or actively (where you do your own research to generate trade ideas). Whatever approach you eventually use, this section seeks to provide the essential tools and structure that will make this process as efficient as possible. 2.2 SMALL CAP BIOTECH TRADER TOOLS 2.2.1 FDA & Clinical Trial Calendar One of the most useful tools for identifying trades in small cap biotech is a good FDA and clinical trial calendar. This calendar lists the exact or approximate date of small cap biotech catalysts. A good calendar will contain the dates of FDA Advisory Panels (including briefing document release dates), PDUFA dates, NDA related filing time estimates, (approximate) Phase 1/2/3 status/data releases and other FDA and company related actions. Putting together an FDA and clinical trial calendar is extremely tedious and time consuming (it requires reading press releases, corporate presentations and FDA/pipeline information for each individual drug candidate of every listed small cap biotech stock!). Luckily, there are very good on-line resources that have done the work for you – a select few are listed in Exhibit 2.1. Exhibit 2.1: FDA & Clinical Trial Calendar On-line Resources Name Web Address BioPharm Catalyst www.biopharmcatalyst.com BioRunUp (subscription based) www.biorunup.com GekkoWire www.gekkowire.com The Biotech Investment Paradigm www.biotechinvestmentparadigm.com It is important to note that all FDA and clinical trial related data should be double checked prior to executing a trade as information contained in on-line resources can potentially be out-of-date – Section 3.7: Pipeline covers how to verify this type of data. 2.2.2 Twitter Account It may surprise you but Twitter is an excellent trading tool (I was initially skeptical of this resource). Twitter allows the user to “follow” active traders, investors, bloggers, analysts and other industry professionals and participants in real-time. Following the Twitter feeds of active users is excellent for trade candidate identification, company specific news and research amongst other uses. Twitter allows one to see what these people are doing and thinking. Most traders or industry professionals with a large “following” also have their own blogs that often detail their trade ideas and/or company research which can be very valuable when assessing opportunities. Information “tweeted”9 on Twitter can often be of high tactical value. News related items tend to (always) hit Twitter faster than major media outlets such as Yahoo! Finance or CNBC – this is because the people you are following often have access to news sources you do not or the news is on a smaller company (most small cap biotech) that does not warrant mainstream coverage. This near “instantaneous” news feature via Twitter is extremely valuable in a live trading situation. For example, I was on vacation and was long Chelsea Therapeutics (Ticker: CHTP) 5.0 strike Calls that were set to expire worthless with about 20 minutes left to trade on a Friday (the stock was around $4.50). Data on one of Chelsea’s Phase 3 drug candidates was slated to be released at any moment. The stock proceeded to immediately spike up to around $6 – there was no news and I had no other information. Did the company release data? What was going on? I checked Yahoo! Finance and the company’s website – nothing. I checked Twitter and I read that someone was on CNBC pumping the stock – this was not Phase 3 data related: I immediately closed out my Calls at a substantial profit with around 10 minutes left to trade. The shares closed at around $5 at the end of the day (the Calls would have expired nearly worthless) – without Twitter, I would have been “flying blind” and most likely would have missed the opportunity. If you actively trade small cap biotech, Twitter is a must have and must use tool in your daily trading arsenal. In order to use Twitter, first set up an account (at www.twitter.com) and then begin to “follow” people. To start following small cap biotech related feeds, you may want to initially follow me: biotechtraderHB. Once you follow me, you can see whom I follow and add those individuals if they pique your interest. Prior to following someone it is often useful to see what kind of information they tweet – this can be accomplished by reading their prior tweets (click on the “tweets” link under their name). If the information seems useful, you can choose to “follow” them. 2.2.3 On-line resources There are some extremely good on-line resources for small cap biotech traders and investors. Exhibit 2.2 provides a select few on-line resources that I view as currently amongst the best. It is important to note that while General News and FDA-related sites are good10 most of the value-added research and trade related ideas are found on the Blogs and Full Coverage sites. Exhibit 2.2: Websites for Biotech Traders GENERAL NEWS: www.biospace.com www.clinicaspace.com www.fiercebiotech.com www.finance.yahoo.com www.thestreet.com FULL COVERAGE: www.biorunup.com (subscription) www.biotechinvestmentparadigm.com www.biopharmcatalyst.com www.biomedreports.com www.gekkowire.com INSIDER ACTIVITY: www.mffais.com (subscription) www.secform4.com OFFICIAL TRIAL DATA: www.clinicaltrials.gov www.fda.gov BLOGS: www.biotechtraderhandbook.com www.seekingalpha.com OTHER SOCIAL MEDIA: www.stocktwits.com OTHER: www.bigcharts.com www.nasdaqtrader.com* www.shortsqueeze.com www.tickerspy.com * Primarily for after-hours trades and trading halt information. 2.3 COMPREHENSIVE INDUSTRY SEARCH 2.3.1 Overview While most on-line resources are useful to identify trade candidates, they tend to cover companies and opportunities everyone else is evaluating at the same time – this can place you at a significant disadvantage. For this reason, it is often advantageous to employ a comprehensive industry search approach to identify trade candidates well before everyone else. Although significantly more tedious and time consuming, this approach often yields substantial opportunities to generate outsized returns. 2.3.2 Trade Candidate Ticker List The first part of this approach is to generate a ticker list. The best way to do this is to use a stock screening tool on either a brokerage website or free web service (such as Yahoo! Finance). A high quality and comprehensive list can be generated by searching under two broad parameters: industry and stock price range. For industry, search under biotechnology, small cap biotech, pharmaceuticals or other healthcare related terms. For stock price range, I suggest a range of $0.50 to $10 or $20 – this will generally produce a high quality list of trade candidates with market capitalizations11 under $500 million. I avoid stocks with prices below $0.50 because the output is usually hundreds of stocks with prices of a few pennies to $0.10 that are generally not worth the time and effort to do follow-up research either because they lack sufficient liquidity, are too early stage, face severe financial distress or any other number of problematic issues. Exhibit 2.3 lists the identified small cap biotech trade candidates using this approach. I include the company name, the ticker and the company website. As the data in Exhibit 2.3 will change substantially over time, it is highly recommend to eventually perform your own search to generate an up-to-date ticker list. 2.3.3 Organization Strategy Once you generate a ticker list, the tedious and time consuming part begins (for the highly motivated person): the individual analysis of the component stocks in the ticker list. A streamlined approach to performing this analysis on each company will be covered in Chapter 3.0: Trade Candidate Analysis.12 Prior to this, however, it is essential to put in place the infrastructure to properly organize your analysis (as you will eventually analyze hundreds of companies). The more organized you are, the more success you will have trading small cap biotech – this is a certainty. No matter how thorough you intend to be, a simple yet highly effective approach is to buy a (large) three ring binder notebook and A-Z letter tabs. For each company your come across, use a single sheet of paper to write your notes (i.e. key dates, critical financial data, analyst estimates, etc.) – it helps to write the company’s ticker on the upper right hand corner of the sheet for easy reference. For each individual company sheet, include a print out of the company’s pipeline chart. Once you are finished, file the sheet alphabetically based on the company’s ticker in the notebook. After looking at few hundred companies you will have a sizeable database (mine is a binder notebook nearly 3 inches thick) of information that you can go back to (frequently) and quickly review if necessary. If you don’t do this, you will find yourself getting confused given the vast number of companies; if you do what I say regarding organization, you will find that having the information at hand (immediately) will save you substantial time and better position you to jump on emerging opportunities (which will, without a doubt, come up). For example, biotech company XYZ just dropped 30%. You recognize said company, and quickly access your notes on the company. You see a trade and feel comfortable putting the trade on immediately (because you know the key elements / key drivers of the company as per your notes). If you are stumbling around, you will miss the opportunity – don’t let it happen to you; it will cost you dearly over time. For Phase I/II companies, simply write the phase of the primary drug candidate in addition to the expected date of review, if any (or additional information if you wish) – this will allow you to build a pipeline list of trade candidates well in advance and give you a huge edge in building your trade positions prior to others (the “day trading hoard”) discovering the company. This will increase the probability of generating huge returns in the future. Believe me on that. CHAPTER 3.0 TRADE CANDIDATE ANALYSIS 3.1 FAST REVIEW STRUCTURE OVERVIEW In order to analyze identified trade candidates, an efficient review methodology must be utilized. In Exhibit 3.1 I present a seven step, streamlined review structure, which I aptly call Fast Review Structure (“FRS”). This review structure has been developed in order to achieve a simple yet extensive analysis as fast as possible. The goal of FRS is to quickly determine if there is a potential, high risk-adjusted return trade and if so, what type of approach (i.e. bearish, bullish, neutral) and trade structure to use. The structure should be used to identify a core list of companies where high potential trades can be made and provide a springboard for further, more in-depth analysis prior to an eventual trade, if necessary. Exhibit 3.1: Fast Review Structure Components Cash Profile Technical Analysis Ownership Pipeline Insider Activity Industry Support Analyst Views 3.2 CASH PROFILE 3.2.1 Overview The fastest and most efficient way to analyze the financial position of a small cap biotech company is to focus primarily on its cash profile. This analysis looks at cash burn, cash per share, net cash/net debt balances and future sources of cash. This information alone will tell you about all you need to know regarding the financial health of the company. The first place you should check for this information is the company’s latest earnings press release. The earnings release will normally include a quick overview of the company’s cash profile often including cash burn estimates and any planned information about future cash sources. Other components of the company’s cash profile, such as cash per share and net cash/net debt balances can be easily calculated with information contained in this release. If you need access to more detailed information, check inside the SEC 10-Q (quarterly report) or 10-K (annual report). For example, ACADIA Pharmaceutical’s (Ticker: ACAD) 2Q’09 earnings press release, located in SEC Form 8-K, contained most all of the information needed to quickly get a handle on the company’s cash profile. The most important information from this perspective is contained in paragraphs three and nine shown in Exhibit 3.2. Exhibit 3.2: ACADIA 2Q’09 Cash Profile Paragraph 3: “At June 30, 2009, ACADIA’s cash, cash equivalents, and investment securities totaled $60.1 million at December 31, 2008. The increase in cash was primarily due to an upfront cash payment of $30 million received in May 2009 pursuant to ACADIA’s collaboration with Biovail, partially offset by cash used to fund operations.” Paragraph 9: “ACADIA continues to anticipate that its cash, cash equivalents and investment securities will be greater than $40 million at December 31, 2009, and that the Company’s existing cash resources and payments from its collaborations will be sufficient to fund its operations at least into the first half of 2011.” Source: SEC Form 8-K. In these two paragraphs, it is revealed how much cash the company has and how long the company expects to survive without raising external funds (i.e. its cash burn). The information needed to calculate cash per share (cash, shares outstanding), net cash/net debt balances (cash, debt) and future sources of cash (milestone and collaborative revenues, existing product revenues) are located further in the release. 3.2.2 Cash Burn Cash burn is one of the key data points in the analysis of a small cap biotech company. It provides a financial timeline to look into the future, identifying when and at what levels future cash balances intersect with key dates (i.e. FDA and clinical trial announcements, debt maturity dates, milestone achievement dates, etc.) thus providing a trader a more informed rationale to both plan and structure trades. It is essential to know this information. Occasionally, companies will not include explicit cash burn calculations in their press release. Under such a scenario, you will need to estimate the cash burn amount yourself. A “quick and dirty” way to estimate cash burn is to use the simple formula below (for quarterly data): = Total Cash / [(R&D + SG&A + other operating expenses - non-recurring expenses +/- net interest expense – total revenue (either from products, license fees, or milestone/collaboration amounts or other revenue amounts)] 13 = Number of Quarters of Cash Remaining For example, using the information contained in ACADIA’s Statement of Operations, in Exhibit 3.3, we get: = 66,152 / [(11,979 + 2,662 + 0 – 0 – 93 – 1,820)] = 5.2 Quarters ACADIA states, as of June 30, 2009, that the company will have sufficient cash to fund operations at least into the first half of 2011 (or approximately 6 quarters) – excluding any external capital raising efforts. As you can see, our quick and dirty calculation of 5.2 quarters is not far off. When doing this type of analysis, make sure to exclude expense and/or revenue amounts that are not expected to re-occur going forward. For example, if the company discontinued research or a trial on a potential drug candidate, your forward looking and ongoing operating expense estimate may be too high and will thus need to be adjusted – if this amount is material, the company will usually mention it in their press release – make a note of it and adjust accordingly. With regards to milestone payments or other collaborative revenues be aware that these are awarded only after meeting certain criteria. For this reason, it is important to always analyze the component parts of a company’s cash burn estimates. It is a good idea to only include funds (perhaps as a scenario) that have been received or are going to be received with absolute certainty. The company may say that they expect to receive uncertain milestone funds, but this is not guaranteed – take notice of this eventuality on your cash burn calculations. 3.2.3 Cash per Share Another useful way to look at cash when analyzing small cap biotech is from the perspective of cash per share. This is obviously calculated by taking total cash (less debt, if any) and dividing by total (diluted) shares outstanding. The cash per share metric is useful from a variety of perspectives. First, it can provide a flash estimate of where the market is valuing a company’s drug candidate(s). For example, Pain Therapeutics (Ticker: PTIE) as of 3Q’09 had total shares outstanding of 42.2 million and total cash and marketable securities of $177.5 equating to cash per share of $4.21 (the company has no debt). This compared to a market share price of $4.90. This implies that the market views the total value of future products at around $0.70 a share (or $29.5 million) that may or may not be correct. Second, the metric can indicate potentially irrational situations where cash per share exceeds price per share (i.e. the current market price). For example, small cap biotechs often trade below cash value preceding Phase III announcements (past examples include Spectrum Pharmaceuticals, Ticker: SPPI; and, DepoMed, Ticker: DEPO) – this presents a huge opportunity to go long. The market is effectively valuing the opportunity at zero (or a negative value) – as such, in a strange way, this represents a “free” trade (however, don’t forget you can still lose money). Finally, a high cash per share relative to price per share represents a sort of free “balance sheet hedge” and in a way diminishes the overall risk of the trade. This value (cash per share) represents a dirty liquidation value of the company. For example, lets assume Pain Therapeutics above is immediately liquidated. Shareholders would receive the net of assets and liabilities. Assume you purchased the shares at $4.90 as above – given the high cash per share your loss would not be the full $4.90 a share. Depending upon the net cash impact from the sale/payment of other assets/liabilities (and excluding legal fees, employee termination costs, etc.), your loss, as a shareholder, would likely be minimal and your liquidation proceeds would likely not deviate far from the cash per share value of $4.70. 3.2.4 Net Cash / Net Debt Balances When analyzing the cash balances of a company, it is obviously important to factor in debt. If the company has debt, you will need to net the debt with the cash amount; that is, if the company has $100 million cash and $50 million debt, the company will have $50 million net cash ($100 cash – $50 debt). If the company has $100 million debt and $50 million cash, the company has $50 million net debt. This is a simple “liquidation method” of determining how much cash buffer the company has should they encounter a failed FDA or clinical trial related event or other financial difficulty – the point is don’t simply look at cash levels. If the company has debt, focus primarily on the maturity date of the debt.14 This information should then be compared to the expected announcement date of the catalyst event. If the catalyst falls before the maturity of the debt, and the company has net debt, and the result is negative, the implications could be catastrophic for the company and its share price. This information can obviously be factored into your trading decisions (both pre and post trade). A good example of this was with Human Genome Sciences (Ticker: HGSI). As of June 30, 2009, the company had $370 million cash and $339 million convertible notes due 2011 and 2012. In addition, the company had $247 million in lease financing (a form of “debt”). Hence, HGSI had $216 million net debt. The company’s initial Phase III announcement date for its lupus drug was slated for July 2009. In addition, the company did not generate substantial revenues and its other drug candidates were still in development. In this situation, a failed trial would have been catastrophic for the company and a trade could have been structured to reflect this outcome (although a bearish stance would have been an abject failure). On another trading note, a good way to assess risk for companies with publicly traded debt,15 such as HGSI, is to follow the trading in the debt. This trading is usually confined only to credit traders on bank prop desks or hedge funds – fixed income traders are generally considered more sophisticated to equity traders on the Street (no offense to equity traders) and as such, movements in credit spreads on a company tend to foreshadow movements in the company’s equity. As can be expected, HGSI’s credit spreads were huge and then began to collapse (the larger the credit spread, the higher the perceived risk). Eventually it became known that HGSI was purchasing their own debt (to retire) at huge discounts – this was a good sign and foreshadowed more positive events to come. If you have access to this type of data, and you are trading a biotech with publicly traded debt, you should use it. 3.2.5 Sources of Cash Small cap biotech companies generate cash from several sources including revenues from existing or acquired products, milestone payments or other collaborative payments, or capital raising efforts in the markets. Since most small cap biotechs generate little to no revenue, it is essential to determine how the company intends to fund itself outside of existing cash on the balance sheet. For companies that generate revenues from existing products or acquired products, it is important to determine how stable this revenue source is and for how long. Since our trade time horizon is a year and a half or less, this information is often easy to forecast and can support your cash burn estimates. This information is usually on the Income Statement under the heading Product Revenues or Royalty Revenue and is further explained in the notes section of the financials. Most companies have some sort of partnership agreement with a major biopharmaceutical company. These agreements include milestone payments that provide for cash payments upon successful completion of various predetermined benchmarks during the development and testing of the drug candidate. Partnership agreements may also include various forms of R&D sharing and/or a royalty structure when/if the drug candidate is approved, amongst others elements. Companies will always make note of the key elements of their partnership agreements either on their website, in press releases or in SEC 10-Q, 10-K or 8-K filings. We will go into further detail on partnership agreements in Section 3.8: Industry Support. The only other general source of funding available to small cap biotech companies is from the capital markets, primarily in the form of secondary equity offerings or some form of hybrid debt/quasi-equity offering that we will not cover given the variability of structures. On a trading note, secondary stock offerings, for our target universe, are generally done either immediately preceding the FDA or clinical trial related announcement (where and when the shares have gained in price substantially) or, to a lesser extent, soon after a successful announcement. Other factors which increase the probability of a secondary offering generally include low shares outstanding (i.e. under 100 million shares outstanding) and less than a year of cash to offset cash burn – so remember this: if your biotech company’s catalyst event is near, and the share price has gained significantly, and the other factors mentioned are present, there is a high probability that the company will do a secondary offering.16 The important elements to note regarding secondary offerings are the number of shares being issued (i.e. the impact of dilution on existing shares), the discount of the share issue and the identity of the investor(s), if known. Obviously the smaller number of shares, the smaller the discount and the more sophisticated the investor(s) the better. As an example, I have included in Exhibit 3.4 a description of a secondary offering by Spectrum Pharmaceuticals (Ticker: SPPI). Exhibit 3.4: Secondary Offering by Spectrum Pharmaceuticals Original shares: 32,995,887 Share issued: 2,936,037 (excludes warrants) Discount: 6.5% (based on price of $7.1525) Dilution: 8.2% Price pre-announcement: $7.65 Price post-announcement: $6.59 Decline (%): 13.9% Days to trade back to pre-announcement level: 42 days Source: SEC Form 10-Q. On a trading note, following the secondary offering the share price will normally experience a mild to massive sell-off on the event. This is usually a good time to add to your position if you are long as the shares normally (although not always) recover to pre-secondary offering levels within a few weeks (when the catalyst announcement has still not been made). Do not read too much into these pre-catalyst sell-offs. Often traders fret that the secondary proves the impending catalyst data will be negative. This is not always the case (it also implies the company knows the outcome, is withholding it, and is thus committing fraud; an unlikely scenario despite conspiracy theories). In most cases, the company is actually doing the prudent thing by taking advantage of the elevated share price in order to raise funds which may not be available in the future should there be a failed FDA or clinical trial related outcome. Also, realize that there are informed and experienced institutional investors who purchased the shares in the secondary offering. These peoples’ careers and reputation are often on the line so their investment is generally not made in haste. Relax. 3.3 OWNERSHIP It is important to get a quick snapshot of the ownership of a small cap biotech company (or any company you intend to invest or trade in, for that matter). Shareholder data is easy to find at either the company’s website or on mainstream financial websites such as Yahoo! Finance. For more detailed information and granularity, check the company’s SEC Form DEF14A. The most efficient way to analyze ownership is to first look at management, then non-management/beneficial holders (greater than 5/10%) and finally institutional holders with less than 5%. Management17 that holds a significant equity stake in the company is usually a good sign. Generally speaking, the higher the percentage management owns, the better – a high equity ownership by management (usually and theoretically) better aligns the goals of management with the goals of the other shareholders. It is worth taking a look at SEC Form DEF14A to gain a better understanding of how management is compensated. This form provides in-depth detail on compensation, including salary, restricted stock awards, option awards, nonequity incentives and all other forms of compensation. As an example, Exhibit 3.5 shows the Summary Compensation Table for MannKind Corp. (Ticker: MNKD) from Form DEF14A. If we look at the summary compensation table, we note that Alfred Mann is not only in management (CEO) but is also a key (if not the key) shareholder with a 41.7% shareholding. Following further analysis, it is discovered that he has provided significant levels of funding for the company in the past. This type of “deep pocketed” shareholder is often advantageous for the funding prospects of the company – take note of these situations. Another element to consider when assessing management compensation is the level of cash compensation in the form of salary and bonuses. Companies with management that take high cash salaries/bonuses relative to equity incentives should be avoided or treated with caution. Cash heavy incentives tend to give the impression (either right or wrong) that management is indirectly looting the company in the short term at the expense of longer term and equity growth oriented shareholders. Next look at the non-management, beneficial owners. These owners will typically be (ultra-high net worth) private investors, mutual funds, hedge funds, investment banks, private equity funds, venture capital funds, pension funds and other institutional investors. It is usually worth a quick internet search on these owners (especially when they own greater than 10%) in order to understand if they are long or short term holders, what their track record is, what other biotech holdings they have (if any), if they are a specialized biotech investor or not, and if they are active or passive regarding management of the company. It is usually better (depending upon your trade perspective) to have a long term holding, (non-activist) specialist biotech fund with a solid track record as an owner than, for instance, a generalized fund with a short term focus – obviously I would want to invest side-by-side with the experts who are in for the long term than those who are simply allocating funds across a large amount of investments. Despite this, there is no guarantee that you will benefit simply because said fund is a major shareholder – there are countless examples of so-called “smart” specialist funds taking major losses on unsuccessful biotech investments. A recent example is of RA Capital Management and their significant holding in Sequenom. RA Capital is considered a sophisticated investor with a solid track record. They took a huge position in Sequenom as they considered it one of the top picks in the biotech space from the perspective of diagnostics. On one rainy day in April 2009, Sequenom issued a press release that the data on one of their key diagnostic products was “mishandled.” The shares plummeted from around $15 to less than $4 in seconds where they still wallow. As you can see, even when you follow the smart money, you can lose big. Special mention needs to be stated regarding activist hedge funds. Activist funds will target underperforming companies and take a position in order to affect “change.” Although they can generate value, I suggest these types of owners be treated with extreme caution as their ultimate goal often differs from other shareholders and they may have ulterior (and unstated) motives that may be bad for your investment/trade. A high level of caution should be used when an activist hedge fund has multiple holdings in, where relevant, both the debt and equity of the company. It is not uncommon for such an activist fund to initiate an enforcement action (such as a debt maturity acceleration) on minor breaches in debt covenants thus forcing a reorganization where debt would be converted to equity (i.e. your old equity would be wiped out). After you get an idea of the major beneficial holders, take a quick look at institutional ownership trends at www.mffais.com. This is an excellent site to quickly see trends in institutional ownership in the company’s shares. The site will show you who has owned the shares, how much, if it is a new holding, if they added to or sold part of their holdings, and if they sold all of their position (amongst other data). This is often quite useful and informative as you may see top-tier funds building or exiting a position. One word of warning, however, the data comes from public records, and as such, is only a snap shot in time (that is, it does not necessarily represent the current, existing shareholding). 3.4 INSIDER ACTIVITY Insider activity is very important as it may demonstrate or provide an indication of confidence or lack thereof in the company’s drug candidate(s) by those closest to the company. This is (obviously) important because these people and entities have “skin in the game.” During the months preceding an FDA or clinical trial related catalyst, insider activity comes under intense public scrutiny so it is something you should both focus your attention on and understand. Insiders include executive officers, directors, or someone or something (i.e. legal entity) affiliated, as defined by the SEC, with the company. This category also includes so-called “beneficial owners” of the company, individuals or entities with greater than 10% interest in the securities of the company.18 Insider activity is reported in numerous SEC forms including Form 3 (Initial Statement of Beneficial Ownership), Form 4 (Statement of Changes to Beneficial Ownership), Form 5 (Annual Statement of Beneficial Ownership), Form 144 (when an insider places an order to sell the company stock) and Schedule(s) 13G/13D/13GA/13DA (required filings for anyone who acquires more than 5% ownership in a company). Luckily, as you are probably aware, you do not need to compile this information for yourself at Edgar On-line (SEC filing website). Most major brokerages and mainstream financial websites, including Yahoo! Finance, compile this data for you and list it on their “insider” action/transaction areas. For Form 4s, discussed below, a very good website is SecForm4.com. Your goal with reviewing insider transactions should be to gain a general understanding or, dare I say, “feeling,” with regards to actions of the owners and management. There are no hard/concrete outputs here (aside from quantifying the net acquisitions or divestments of total insider transactions should you decide to undergo such analysis). Insider transactions are not always indicative of what the future holds. However, high insider selling is usually a stronger indication of problems ahead than the equivalent of high insider buying. There are many examples of high insider buying preceding negative FDA or clinical trial data failures so don’t be fooled. High insider selling, however, sends a different signal, one where there is lack of confidence preceding a trial in the first place. So read into insider transactions with a high level of caution. Usually, insider transactions will not provide the bedrock from which to base your entire trade, as such, simply use this data as an analysis enhancer after your full work. The questions to ask, listed in Exhibit 3.6, are mostly common sense but they have been included for completeness. Exhibit 3.6: Basic Questions Regarding Insider Transactions 1. What is the general trend of insider transactions over the past year? - (Significant) overall more buys than sales, i.e. 1-2x // bullish - (Significant) overall more sales than buys, i.e. 1-2x // bearish - Small to no trend // neutral 2. What is the nature of the trend of the divestments or acquisitions made? - More recent sales in increasing manner // bearish - More recent buys in increasing manner // bullish - More recent sales in decreasing manner // bullish to neutral - More recent buys in decreasing manner // bearish to neutral 3. How are insider transactions distributed? - Acquisition by several insiders during same timeframe // bullish - Divestment by several insiders during same timeframe // bearish - Sale or divestment by single insider/no clear distribution // neutral It is often necessary to find out the nature of a specific insider transaction. This may be required if an insider transaction seems suspicious. For example, why did the CEO or CRO (Chief Research Officer) sell a large amount of shares prior to a major Phase III announcement? To obtain more granularity, it is usually good to check Form 4 (Statement of Changes to Beneficial Ownership) – Form 4 lists the changes in holdings so it is usually the best form to check for recent activity. Form 4 lists changes in insider positions that occurred in the past 2 days – hence this is near real-time regulatory data and hence of high value. This form is useful as it lists what was purchased/sold (non-derivative, such as common stock, or derivative security, such as options), when, how much, what price and the reason. Exhibits 3.7 and 3.8 provide a sample Form 4. A Form 4 is simple to understand. It is divided into three sections: (1) Section 1 details the personal information of the individual doing the insider transaction (2) Section 2 lists non-derivative transactions, i.e. common stock and (3) Section 3 lists derivative transactions (i.e. puts, calls, warrants, options, convertible securities). The “reason” element, what I consider the most important information contained in Form 4, is listed in Table I, column “3. Transaction Code,” Table II, column “4. Transaction Code,” and the footnotes, which are located at the bottom of Table II under “Explanation of Responses.” In Exhibit 3.9, I have listed the so-called Transaction Codes as defined by the SEC. These codes will tell you the general nature of the transaction. For example, a Transaction Code “P” denotes an “open market or private purchase of non-derivative or derivative security,” this can be construed as bullish. A Transaction Code of “S,” which denotes an open market sale, can be construed as bearish. Likewise, a Transaction Code of “M,” exercise or conversion of derivative security, can be either although it is usually indicative of an insider who is exercising stock options to stock as a precursor to a sale. Codes under Rule 16b-3, in Exhibit 3.9, refer to transactions under SEC Section 16(b) that covers the “Short Swing Profit” rules applied to insiders. Section 16(b) requires, amongst other provisions contained in the Section, that company insiders return any profits made from the purchase and sale (or sale and purchase) of company securities if both transactions occur within a six month period. This is basically to prevent inside trading abuses. The SEC has adopted several exemptions to the SEC 16(b) short swing profit rule, such as 16(b)-3 (“Transactions between an Issuer and its Officers/Directors”) where profit recapture provisions do not apply. Insider transactions with these codes should be taken as neutral. One final note is in regards to transactions effected pursuant to Rule 10b5-1 that reference a “trading plan adopted by reporting persons.” This reference will be found at the bottom of the Form 4 in the footnotes and is very important as it denotes trades that were planned well-in advance and in accordance to an adopted “trading plan” developed by the company. Hence, if you see a large insider sell/buy prior to a Phase III and in the Form 4 the sale/buy is pursuant to Rule 10b5-1 contained in the footnotes, do not concern yourself (if you are long/short) – this should be construed as neutral.19 In Exhibit 3.8, in footnotes 2 and 4, we see that the common stock and option divestitures made by this insider (the CFO) of Savient Pharmaceuticals (Ticker: SVNT) was made pursuant to Rule 10b5-1. Again, do not read too much into these transactions unless there is overwhelming data to prove otherwise (i.e. insider sales greatly exceed insider buys or vice versa). For example, sales by senior management may not be a negative factor if these individuals hold a sizeable position in the shares of the company. It is possible, and not particularly unreasonable, that the insider is diversifying their personal assets even if not under a trading plan (i.e. the transaction is an outright sale). Again, if your suspicion is drawn, check the Form 4 to gain a better understanding of the reason behind the transaction – this is a preferable route than listening to market rumors about insider activity. Finally, it is important to mention that large sales/buys (i.e. around 1 ~ 5% of total shares outstanding) by major beneficial holders, especially specialty hedge funds or other institutional holders (banks, mutual funds) need to be carefully scrutinized. Although not always the situation, a large sale by one of these types of insiders could be a sign of serious trouble ahead. On the other hand, the opposite may be true for large buys. If you encounter this situation, do a news search of the fund and the name of the biotech company and see what information you get, if any. See if the investor is also selling/buying stakes in other similar companies – this information can be found by searching under the entity’s legal name (or fund’s legal name) under mffais.com. If you are concerned, do an additional amount of due diligence. 3.5 ANALYST VIEW It is valuable to assess how analysts view a particular biotech company especially prior to an FDA or clinical trial event. The most useful information to cull from analysts during a FRS process is (1) the stock price target for both successful and unsuccessful catalyst outcomes and (2) the timing of said announcement, where relevant (i.e. assuming an exact date has not been set). Regarding price target estimates, analysts will generally be accurate given the significant amount of time and research they spend when assessing market potential of the drug candidate, their discussions with executive management in addition to conversations with industry insiders and specialists. It goes without saying that you will probably not be able to assess a price target range better than most analysts. Analysts will often (although not always) provide a more precise estimate of when FDA or clinical trial data will be announced. This can be attributed to the analyst’s knowledge of FDA timelines or trial procedures and time elements within a trial’s structure. Companies usually provide a very rough estimate of when they expect results to be announced (for example, “fourth quarter,” “midyear,” “late in third quarter,” “early October”). More specific information on the date of the announcement is absolutely vital as it will allow you to structure the optimal position well in advance. Both the price target range and timing information can and should be used to help guide the trade structure you will eventually use. For example, analysts covering ABC stock, which currently trades at $7.50, estimate a successful trial will result in a price of $12.00 per share and an unsuccessful trial will result in a price of $1.00 per share. Analysts expect the announcement to be in mid-November. Using this information, you would structure your option strategies using the $1.00/$12.00 range as an initial guidepost for bullish, bearish or neutral strategies (depending upon the results of your own analysis). Also, you would need to make a decision whether or not to structure your strategy in the November or December options. This can be very important as you may structure a net long position in November options and the ultimate result could occur in the fourth week of November (hence, your November options will have already expired). Although you may have made money on the increase in volatility (Vega) and price (Delta) preceding the announcement, you will not be involved in the “action” during the actual announcement, and thus you will miss either the substantial gain or fall of the shares (which could be either positive or negative depending on what strategy you employed). Of course, you could have played it this way on the short volatility side, where you would have been net short with the expectation that the announcements would be after expiration, thus generating you extremely high returns by selling, the now worthless, high volatility November options – a high risk strategy indeed, but very profitable. As you can see, the trade permutations are virtually unlimited. You may now think that I completely trust analysts – to put it simply, I don’t (nor should you). As stated, I only trust them with regards to price range estimates and timing of announcement estimates. Regarding trial success estimates (i.e. the trial will be a success or failure or outcome of FDA-related decisions), however, I tend to discount what analysts say simply because they are usually wrong. This is not to say that their analysis is flawed – elements of it are usually quite good as already discussed. It is simply a statement that it is literally impossible for analysts to accurately predict which trials will be successful and which will be failures given the significant complexity and number of variables involved – it is often nearly a coin toss. Given that most trials fail, most analysts err on the conservative side by “predicting” a failure. The same can be said for FDA decisions or outcomes of Advisory Panels. Case in point, among the largest biotech success stories in the past several years, Dendreon and Human Genome Sciences, the analyst consensus for both was total failure. If you listened to the analysts, you would have been on the sidelines and missed out on over 500% gains. Likewise, two high profile FDA Panels for diet drugs in 2010 resulted in near opposite outcomes to analyst consensus – Vivus’ Qnexa was expected to pass (it failed) and Orexigen’s Contrave was expected to fail (it passed!). There are countless other examples where consensus proved to be wrong. Be cognizant of this feature of small cap biotech catalyst trading and prepare with a sense of skepticism with regards to consensus thought. 3.6 TECHNICAL ANALYSIS It is important to take a look at a company’s charts when approaching a catalyst event. If you are a big proponent of technical analysis (I am), you need to realize that the technical analysis “rules” as applied to non-biotech companies do not apply to biotech companies with an approaching catalyst event. Nearing such an event, most, if not all, technical indicators become meaningless – at this point, the only thing that matters is the binary announcement. As such, do not read too much into daily price action – it will be volatile. When using technical analysis, the only useful information is with regards to prior trading levels within the past several years (ideally 5 years) on the same/similar catalyst. For example, it is quite common for a company to have had a Phase III failure where the FDA required additional data (which is achieved through several additional years of studies). When this happens, the company’s stock will have sold-off substantially. A 3 to 5-year chart will often quickly identify said past events. The important data to cull from this information is the price level prior to the announcement and the level immediately after. This data, in most cases, can give you an idea where the price should 20 trade prior to the most immediate trial announcement in addition, where applicable, to the level where it will likely trade after another failure (this downside value will often be a minimum value, as a second failed Phase III study, depending on the individual circumstance of the company, will often prove fatal to the company). A perfect recent example of using prior trading levels is Dendreon (Ticker: DNDN). Several years ago, in May 2007, the FDA stated that one of the company’s leading Phase III drug candidates targeting prostate cancer, required additional tests prior to approval. Prior to this news, the stock traded from around $4.50 a share to as high as $25.00 a share on excitement regarding the drug’s blockbuster potential. The FDA’s negative decision sent the shares plummeting back to around $5.00 a share. In April 2009, Dendreon having worked several years on addressing the FDA’s issues, once again prepared to announce Phase III results. Prior to the announcement, the shares traded up from $5.00 to $7.00 a share. Phase III announcement was positive sending the shares back to the twenties.21 In this case, historic technical levels proved quite accurate and useful. If you use prior technical levels in your analysis, it is important to be cognizant of the need to adjust for the impact of share dilution on the company’s market capitalization. For example, stock XYZ’s shares traded at $5.00 with 10 million shares outstanding (for a market capitalization of $50 million) immediately preceding an FDA decision on the company’s late stage drug candidate.22 The result was negative (i.e. a “Complete Response Letter”) and XYZ’s shares crashed to $1.00. Several years later the company announced that it would release new top-line data on the same drug candidate in about six months. Since the failure, however, the company issued 10 million shares of common stock. The shares now trade at $2.00 (for a market capitalization of $40 million; i.e. 20 million shares x $2.00 a share). Assuming the value of the drug candidate has not changed materially, it would be misguided to assume that the shares should trade to $5.00, the prior technical level. Why? Because that would place the value of the drug candidate at nearly double its former value, i.e. $100 million versus $50 million. A more appropriate analysis would be to assume the former value, $50 million, and divide by fully diluted shares outstanding, 20 million, which would yield an initial run-up price of around $2.50. The point is: don’t ignore the impact of share dilution if you use prior technical levels in your analysis. One final word with respect to the use of technical analysis: be cognizant of other corporate actions, such as stock splits (especially reverse stock splits) on price history. For example, if one looks at the price history of Adventrx (Ticker: ANX) during 2010, it seems as though ANX was at a time a $12.00 stock. This is not true – Adventrx did a 25-for-1 reverse stock split which converted the sub-$0.50 penny stock to one that now trades near $2.00. Don’t assume the stock is going “back” to $12.00. If you see huge price spikes and massive volatility on a 1-year chart, the stock in question probably did a reverse stock split and should be viewed with an additional level of scrutiny.23 3.7 PIPELINE A company’s pipeline includes all existing drug development programs the company is working on. This may include pre-clinical trials, Phase I and Phase II trials and finally Phase III and all categories of post Phase III products/candidates. A company’s pipeline can be found on their website, usually with an explicit link to the data which is often displayed as a chart. It is often useful to print out the pipeline page, make any appropriate notes and file in your database for future reference. Companies that avoid listing their pipeline typically only have drug candidates in pre-clinical and Phase I trials – avoid these companies. When analyzing a company’s pipeline, first focus on their Phase III candidates. For each candidate listed, there is usually a link to information regarding more detailed data about the drug, trial structure, the status of the Phase III trial and sometimes (although not always) the estimated completion and reporting of data from the Phase III trial. The key information at this juncture is to determine when the results of the trial are expected. If this is not stated on the website check the company’s most recent quarterly (or annual) earnings statement. If the timing is still not estimated, it is likely that the results are slated for a point in time more than 1 to 2 years – you should make a note of this and file this company under potential future opportunities. It is likely that there will not be options available to trade on the name during the time frame (and if there are, the spreads will kill any successful trade) and as such you will need to buy the stock. Again, the event catalyst is too far in the future, so I suggest you move to another company. Next, take a quick look at the other Phase II and Phase I programs and make a note of timing if available. As an example, Exhibit 3.10 displays the pipeline of XYZ Corporation, a company focused on the development of drugs in the oncology (i.e. cancer) space. This chart and its associated links provides an excellent snap-shot to get an idea about what drugs XYZ is developing and what stages each specific drug is in. From the chart above, we can quickly identify that this company has one Phase III candidate (XYZ-100 which targets lung cancer). Our next move should be to identify when the key date for information is expected. Clicking on XYZ-100, we identify the trial history of the drug candidate but there is no information on result dates. Next we check news under Investor Relations part of their website. The best place is a recent quarterly earnings announcement. In the 2Q’09 earnings press release, under Corporate Progress and Guidance, we find the following statement: “We expect to report top-line results from the XYZ-100 Phase III trials on November 5, 2009. If the top-line results are positive, we plan to submit a New Drug Application with the FDA by year-end, targeting approval and commercial launch of XYZ-100 in 2010.” We now have an exact action date (hopefully) – our work on this aspect of our analysis is now complete. Make a note of the other drug candidates and move to the next part of our analysis. A potential red flag, depending on your point of view, is a company with a few early stage product candidates and/or a single Phase III product candidate – a failed trial in these situations (or an adverse FDA related decision) will often result in significant share declines. This type of situation should factor prominently into the trade structure you use. ABC Pharmaceuticals provides an example of this situation. Looking at the company’s pipeline in Exhibit 3.11, we see that they have a single Phase III drug candidate and several Phase I candidates. Upon searching, we see that Phase III pivotal data is due for mid-June 2010. Looking at their financials, we note that cash at the current burn rate will only sustain the company into 3Q’10 (as of 1Q’10) – hence, this is a make or break situation for the company. A failed Phase III could result in several additional years of trials requiring significant financial resources (which the company does not have). As the company only has one Phase III and a few Phase I candidates, important strategic decisions will need to be made if there is a failed Phase III. For example, the company will need to assess if they can adequately address issues related to the failure. Also, the company may need to terminate Phase I trials on other candidates in order to conserve funds. This is a very ugly situation – make sure you understand a company’s pipeline and implications for failed late stage trials or adverse FDA decisions. 3.8 INDUSTRY SUPPORT It is important to assess what industry partnerships, if any, the company maintains for the development of select drugs in its pipeline. The backing of a major biopharmaceutical company such as Glaxo, Novartis, Merck, Abbot or Pfizer, for example, provides not only legitimacy/credibility to the company’s product potential, but also experience with ushering the drug through the various phases of drug development (hence theoretically improving the probability of success) and financial (through milestone payments and other collaborative revenues), commercial and/or marketing incentives leading up to and after drug approval. Post approval, the partnership may result in the partner acquiring the company. The best place to find information on the company’s partnership(s) is usually under its pipeline information area on its website. This will generally be a starting point to gain information regarding the nature of the partnership. For more detailed information check the quarterly press releases or in the 10-Q and the 10-K. Partnerships, collaborative agreements and other types of structures (collectively, “partnerships”) will generally contain up to four parts: up-front cash payments, various milestone payments for achievement of specific clinical and/or regulatory goals, R&D expense sharing, and post-approval royalty agreements. The key element to focus on in the partnership agreement, for our purposes, is the amount and timing of the milestone payments. As the company progresses in the drug development process, the milestone payments contained in the partnership agreement obviously become more and more important due to continued cash burn experienced by the company. As mentioned in Section 3.2.2: Cash Burn, it is important to get a handle on where the company is with regards to expected timing of achieving a milestone payment and the amount of cash available to bridge this time gap. Again, this information will almost always be listed (either directly or indirectly) in quarterly earnings announcements or in the 10-Q or 10-K. An example industry partnership is Pain Therapeutics’ (Ticker: PTIE) agreement with King Pharmaceuticals (Ticker: KG) for the development of one of their drug candidates. The company entered into a strategic alliance with King back in 2005. The structure of the strategic alliance is contained both under the pipeline portion of their website and in SEC filings (10-K, 10-Q, 8-K) and provides good information to assess potential value of their drug candidate with success. For example, terms of the agreement include a $150 million upfront cash payment, $150 million in clinical and regulatory milestones and $100 million in research and development expenses. In addition, the agreement calls for a 20% royalty on product sales amongst other elements. When evaluating a just announced partnership deal, do not be deceived by the initial (often big) headline number – most of the value may be back-ended (via clinical and regulatory milestone and/or royalty agreements) and is thus uncertain, whether or not the company will ever capture it. The biggest immediate impact on the share price will be from an up-front cash payment as this immediately and directly contributes value. For example, if XYZ stock announces a $250 million partnership deal, of which $50 million is an up-front cash payment, and the company has 25 million shares, XYZ stock should trade up between $1 to $2 per share ($50mln / 25mln = $2). Milestone payments, R&D expense sharing, and royalty amounts, although important, will normally have lesser immediate impact (this obviously may or may not hold true depending upon the situation). A partnership with a major biopharmaceutical is a potential success enhancer and can add immediate and sustained value to the small cap biotech company in the form of cash payments and other types of support. By no means, however, should one assume that it guarantees success – again, within the scope of small cap biotech trading, the outcome is never a certainty. 3.9 CONCLUSION If you spent at least a few minutes on each topic in the FRS, you have taken the important first step in developing a successful trade. At this juncture you should have some idea regarding the strengths and weaknesses of each company in the trade universe. Using this knowledge should improve the probability of a successful trade as it will provide you with an idea whether or not you should approach the trade with a bearish, bullish or neutral stance in addition to having some idea at what price level(s) and at what time period(s) to structure your trade. CHAPTER 4.0 OPTION BASICS 4.1 OVERVIEW This chapter is structured to provide an overview of options from a trading perspective. The primary goal is to provide the reader a conceptual understanding of how options work and how they can be used to make money. For this reason, this chapter will not include arcane theoretical discussions on option pricing, mathematical models, etc. – I’ll leave that to the academics. I intend to focus on what you need to know to trade options in real life situations. If you already have a solid grasp of options, feel free to skip this section and move to Chapter 5: Trading Strategy & Tactics. 4.2 CONCEPTUAL FRAMEWORK It may surprise you, but an option is very easy to understand. In its most basic form, an option is an exchange-traded contract between two individuals to either buy or sell the stock of a company (the “Underlying” Stock) at a specific price (the “Strike” Price) until the contract expires (the “Expiration” Date). For this right, the buyer of the option pays and the seller of the option receives, an amount of cash known as the “Premium.” There are two types of options: the “Put” and the “Call.” A Put is the option (held by the buyer) to sell the Underlying stock at a specific Strike Price until the Expiration Date.24 A Call is the option (held by the buyer) to buy the Underlying stock at a specific Strike Price until the Expiration Date. An option is thus defined and identified by these four elements: Underlying Stock, Expiration Date, Strike Price and Type (Put or Call). Exhibit 4.1: Key Option Terms Underlying The stock on which the option trades Strike The price at which an option buyer can purchase (Call) or sell (Put) the Underlying stock Expiration The date the option expires Premium The amount the option buyer pays or the option seller receives for the option Put The option to sell the Underlying at the Strike by Expiration Call The option to buy the Underlying at the Strike by Expiration For every Put Buyer there is a Put Seller. Likewise, for every Call Buyer there is a Call Seller. You, as an individual trader/investor, can choose to be a Put Buyer, a Put Seller, a Call Buyer or a Call Seller—these are the four fundamental option positions.25 At the most basic level, a trader (or investor) chooses to buy or sell Puts or Calls to gain a specific risk exposure in an Underlying stock in order to capture a desired return. This is similar to the motives of a stock trader and/or investor. For example, if an investor likes ABC stock, the investor will buy ABC stock (i.e. gain a long or bullish risk exposure to ABC stock) with the desire that ABC stock increases in price (thus capturing a desired return). Likewise, if a trader is negative on ABC stock, the trader will sell short the stock (i.e. gain a short or bearish risk exposure to ABC stock) with the desire that ABC stock decreases in price. Using stock, the choice for an opening position is limited to either buy or to sell short. Options, however, greatly expand risk exposure choices. Below I list these choices and the sentiment they represent for the four fundamental positions:26 - A Put Buyer is Bearish on the Underlying stock27 - A Put Seller is Neutral to Bullish - A Call Buyer is Bullish - A Call Seller is Neutral to Bearish 4.2.1 Option Buyer versus Option Seller It is very important to understand the concept of Option Buying versus Option Selling and the implications with regards to initial P&L,28 risk and return. Here is the difference: An Option Buyer: Pays money to initiate the trade (i.e. the individual Buys the option, either a Put or a Call, at the Ask) Risk is defined and equal to the amount paid to initiate the trade Return is undefined An Option Seller: Receives money to initiate the trade (i.e. the individual Sells the option, either a Put or a Call, at the Bid) Risk is undefined Return is defined and equal to the amount received to initiate the trade The distinction is clear and unambiguous: an Option Buyer pays cash up-front for the potential to generate undefined returns (in certain situations, theoretically unlimited returns) while risking the amount paid while an Option Seller receives cash up-front for the potential to keep this cash while taking an undefined risk (in certain situations, theoretically unlimited risk). 4.2.2 The Option Chain A good way to learn about options is to study the topic in the actual format used in a real-life trading situation: from the Option Chain. When you trade options, you will trade from Option Chains contained on your broker’s website. Exhibit 4.2 provides an example of a basic Option Chain for ABC stock for the August “Series” as displayed by a major broker. A Series includes all of the options (i.e. all Strikes for both Puts and Calls) with the same Expiration month. For example, the August Series includes all options that expire in the month of August. At the most basic level, an Option Chain lists the Bid and the Ask prices for both the Puts and Calls for each Strike in a Series. A basic Option Chain will also include Volume and Open Interest (“OI”). Most brokerages allow you to customize Option Chains (by including, for example, the Greeks or levels of implied volatility, both to be discussed later in this Chapter) but the most basic elements are those listed in Exhibit 4.2. The Bid and Ask are the current market prices for either the Calls or the Puts (this is the “Premium” value mentioned previously). The Bid is the current market price to Sell the option, and the Ask is the current market price to Buy the option. It should be noted that this differs from the “Last” price, which was the last price where the option traded – this could have been seconds ago, or possibly months ago. Never trade using the “Last” quote, always use the Bid or Ask – this is obvious but still merits mention and emphasis. Let’s do a few basic trades using the data contained in the Option Chain in Exhibit 4.3: If I want to buy 10 XYZ SEP 15.0 Strike Calls, I would check XYZ stock’s September Option Chain. At this moment, the SEP 15.0 Strike Call (bolded) is trading at 2.08 Bid / 2.13 Ask (like a stock price, Premium values, i.e. the Bid or Ask, are constantly changing). Since I wish to buy the Call, I would pay 2.13 per contract (the “ASK”). Here is the (very simple) math: = Premium x # of Contracts x Multiplier29 = Total Cost (not including commissions) … in numbers: = 2.13 x 10 x 100 = $2,130 Hence, I would pay $2,130 (Debit) to initiate this trade. Let’s say, for example, that I wish to sell 10 XYZ SEP 15.0 Strike Calls. In this situation, I would sell the option at 2.08 per contract (the “BID”). Here is the math for this situation: = 2.08 x (10) x 100 = ($2,080) “( )” denotes selling and hence a Credit. In this example I would receive $2,080 for selling these Calls. If I want to buy 30 XYZ SEP 14.0 Strike Puts, I would check the XYZ Option Chain again. At this moment, the SEP 14.0 Strike Put is trading at 0.59 Bid / 0.61 Ask. Since I wish to buy the Put, I would pay 0.61 per contract. Here is the math: = Premium x # of Contracts x Multiplier = Total Cost = 0.61 x 30 x 100 = $1,830 Hence, I would pay $1,830 (Debit). For a final example, let’s say that I wish to sell 30 XYZ SEP 14.0 Strike Puts. In this situation, I would sell the option at 0.59 per contract. Here is the math for this situation: = 0.59 x (30) x 100 = ($1,770) In this example, I would receive $1,770 for selling these Puts. Easy, right? 4.2.3 The Importance of Understanding The Bid / Ask Spread In both situations above, since we purchased/sold at the market Bid/Ask quote, our P&L immediately following the trade would show a loss. If you have never traded options, and the Bid/Ask spread is wide, and you trade at the Bid/Ask, you may be shocked (at the immediate negative P&L impact in your brokerage account). This is due to the fact that there is a “spread” that you need to “pay.” This is the Bid/Ask spread, which basically (supposedly) compensates the market maker for taking the risk (or taking the “other side”) of doing your trade. For the 10 XYZ SEP 15.0 Strike Call example in Exhibit 4.3, the Bid/Ask spread is 0.05 wide (= 2.13 – 2.08 = 0.05). In actual dollars and cents for the trade, this equates to $50 (= 0.05 x 10 x 100 = $50). Depending upon how your brokerage quotes your position, you will show an immediate loss on your trade of either $50 (if your broker quotes the price to exit the trade, i.e. if you are long, the price to get out and if you are short, the price to cover) or $25 (if your broker quotes on a mid-price basis, i.e. the average of the current Bid/Ask). For 10 ABC AUG 90.0 Strike Put (Exhibit 4.2), the Bid/Ask spread is 0.35 wide (= 9.90 – 9.55 = 0.35) which equates to an immediate negative P&L hit of $175 (= 0.35/2 x 10 x 100) for a mid-price basis quote.30 The spreads for XYZ and ABC, however, are not that wide. In certain illiquid situations (nearly all situations in small cap biotech), however, the spread can be extremely wide to seemingly pointless/outrageous. For example, Omeros Corp. (Ticker: OMER) AUG 2010 5.0 Strike Put as of this date is trading at 0.00 Bid / 4.90 Ask (a spread of 4.90) with the stock trading at $5.46. This is a completely ridiculous quote – only a fool would trade at this level. If I were to buy this Put, it means that I would be willing to pay $4.90 to get $0.10 of downside protection—also, I would take an immediate $2,450 loss if I purchased 10 contracts! If I were to sell this Put (as an opening trade), it means that I would be selling the option for zero thus taking a full $5.00 of downside risk – I would get paid absolutely nothing to take all the risk, a true sucker’s bet if there ever was one. This quote is actually an “open invitation” to make a “fair” offer on the option (either on the Bid or Ask side). The examples just discussed demonstrate the absolute importance of assessing the Bid/Ask spread prior to initiating a trade – don’t get blind-sided by the spread. In Section 5.6: Never Trade at the Bid or Ask, I discuss strategies how to minimize the amount of spread you need to pay – this knowledge alone will save you thousands of dollars. 4.2.4 Volume and Open Interest As mentioned, the other basic information included in an Option Chain is Volume and Open Interest. Volume is easy to understand: it represents the total number of options traded for each Strike during a day (just as the volume for a stock represents the total number of shares traded during a day). For example, the SEP 16.0 Strike Call volume as of this day, June 2, was 564 contracts (see Exhibit 4.3). This means that 564 contracts (options) were bought/sold during the day. On the same day the SEP 18.0 Strike Call traded 2,192 contracts, the most active strike for this Series. Volume is a very useful metric as it shows where most of the trading action for the day is occurring. Many inferences can be made reading daily volume data. This will be discussed in further detail in Section 5.11: Monitor Option Activity Pre-Catalyst. While volume represents the daily activity for each option, Open Interest represents the net increase or decrease in the total number of options traded (opened and closed) since the inception of the Series. For example, the Open Interest for the XYZ SEP 18.0 Strike Calls in Exhibit 4.3 is 4,435. This means that a net total of 4,435 option contracts have been opened/remain open since the Series inception. It is important to note that daily Volume does not always equate to Open Interest – that is, just because a day’s Volume was, for example, 500 contracts, it does not mean that Open Interest will increase by 500 contracts. To expand this point, Exhibit 4.5 shows daily Volume, Open Interest and Net Change for the ABC 5.0 Strike Calls. On Day 1, Open Interest was 10,000 contracts – a net total of 10,000 ABC 5.0 Strike Calls have been opened (and remain open). During Day 1, 500 contracts traded. On Day 2, Open Interest is now 10,500 contracts, which means all of the Volume on Day 1 was from new (initial) contracts.31 On Day 2, contract Volume is 300. On Day 3, Open Interest is now 10,700, a net increase of 200 contracts. This means that of the 300 contract Volume during Day 2, 100 were closing positions and 200 were opening (initial) positions. During Day 3, 1,500 contracts trade. On Day 4, Open Interest declines by 1,500 contracts, the entire Volume experienced on Day 3. Open Interest is a very useful metric as it gives you a snapshot into the money flow in the various Strikes of both Puts and Calls. This can at times allow you to gauge general sentiment in the Underlying shares. In some situations, it is extremely important to actively monitor and interpret Open Interest – this is covered in Section 5.11. 4.2.5 Option Expiration Before we continue, it is important to quickly discuss the finer points of Option Expiration. Options expire on the Saturday immediately following the 3rd Friday of the expiration month.32 This sounds confusing but it is not – if you look at a calendar, it is quite simple. The September 2010 Series expire on Saturday September 18, 2010 – which happens to be the Saturday following the 3rd Friday in the month of September. This construct is true for all months in the year. Make sure you don’t think in terms of the expiration being in the 3rd week of the month. For example, Exhibit 4.6 compares the September 2010 and January 2011 Series in terms of Expiration week. Options for the September 2010 Expiration expire in the 3rd week. Options for the January 2011 Series, however, expire on Saturday the 22nd. Technically, this falls on the fourth week in the month of January. Don’t make this mistake: if you stick to the 3rd Friday concept, you can’t go wrong. Your broker website should list the expiration date for each Series should there be any confusion. Attention to such a seemingly small detail may appear unimportant but nothing can be further from the truth – knowing exactly when a Series expires is extremely important when planning trades in the small cap biotech space – it can either cost or save you thousands of dollars. You absolutely must know this information. 4.2.6 Intrinsic and Extrinsic Value An option’s value is divided into two segments: intrinsic value and time value (also referred to as extrinsic value). Intrinsic value is the amount the Strike Price is below the Stock Price (for Calls) and the amount the Strike Price is above the Stock Price (for Puts). In certain situations, intrinsic value is equal to zero. Extrinsic Value is the extra amount of the option’s value that is not Intrinsic Value. In certain situations the Extrinsic Value comprises the total value of the option. For example, Exhibit 4.7 lists the Option Chain for the November Series for EFG stock. The NOV 45.0 Strike Call is currently trading at 4.55 Bid / 4.60 Ask with EFG at $47.26. The intrinsic value of this Call is 2.26 (= $47.26 – 45.0). The extrinsic value of this Call (using the Ask price) is 2.34 (= 4.60 – 2.26). Now let’s look at the 49.0 Strike Call. In this situation, the intrinsic value is zero – the 49.0 Strike is greater than EFG’s stock price. As such, the entire option is comprised of extrinsic value, which equals 2.38 (again, using the Ask price). Let’s look at the Puts. The NOV 48.0 Strike Put is currently trading at 3.60 Bid / 3.65 Ask again with EFG at $47.26. The intrinsic value of this Put is 0.74 (= 48.0 -$47.26). The extrinsic value (using the Ask price) is 2.91 (= 3.65 – 0.74). Now let’s look at the 46.0 Strike Put. In this situation, the intrinsic value is zero – the 46.0 Strike is less than EFG’s stock price. As such, the entire option is comprised of extrinsic value, which equals 2.77 (again, using the Ask price). The knowledge of an option’s intrinsic and extrinsic value is usually most important prior to executing a trade. This is a quick and simple way to double-check your trade to avoid any (obvious) errors or poor trading decisions. For example, the FEB’11 6.0 Strike Call of Sangamo BioSciences (Ticker: SGMO) was trading at 1.15 Bid / 1.55 Ask as of December 28, 2010 with the shares quoted at $7.11. If you owned the Calls at a profit and wished to exit the position, you would be ill advised to sell at the market Bid of 1.15. At this price, the option only carries $0.04 of extrinsic value ($0.04 = [6 +1.15] - $7.11) – this is a ridiculous Bid as it assigns virtually no value for the additional 52 days left to expiration (with a Delta not even close to 1). If you fired off the trade without putting the Call’s market Bid premium into perspective, you would without a doubt be leaving money on the table. The key point: whatever the situation, it is always important to be cognizant of the make-up of the option premium you are either buying or selling. 4.2.7 “Moneyness” An option can either be in-the-money, at-the-money or out-of-the-money. An in-the-money option has intrinsic value. Thus for a Call, an option is in-themoney if the Underlying stock price is greater than the Strike and for a Put if the Underl

domain: economics