Options Trade of the Day: An Orexigen Therapeutics Bull Call Spread

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Orexigen Therapeutics Inc. ( OREX ) has come under heavy scrutiny lately, as the company prepares to present its weight loss drug, Contrave, before a Food and Drug Administration (FDA) panel next month. The company's competitors have already suffered setbacks at the hands of the FDA. The government agency denied Arena Pharmaceuticals Inc.'s ( ARNA ) application for lorcaserin on Oct. 23, while VIVUS Inc.'s ( VVUS ) weight management drug, Qnexa, was also rejected by the FDA in late October.

Contrave goes before an FDA panel in December, with an official decision from the FDA expected in January, which explains the recent jump in call volume on the security. For instance, call activity today has surged to more than 6.5 times the stock's average daily call volume, with some 5,200 of these bullishly oriented contracts changing hands so far. The most active contract has been the December 7 strike, with nearly 2,000 contracts crossing the tape.

Nestled amid OREX's call activity today, we find that one trader is betting on a positive recommendation for Contrave from the FDA panel. Specifically, 1,000 December 7 calls traded at about 11:03 a.m. Eastern time on the Chicago Board Options Exchange ( CBOE ). These contracts crossed at the ask price of $1.60, or $160 per contract, and were marked "spread." At the same time, 1,000 December 10 calls, also marked "spread," changed hands for the bid price of $0.85, or $85 per contract. The end result is a vertical call spread, more commonly known as a debit spread , on Orexigen Therapeutics. This options strategy is also known as a long call spread, or a bull call spread.

OREX December 7 and 10 call volume details

The Anatomy of an Orexigen Therapeutics Vertical Call Spread

Breaking down this debit spread position, the trader purchased 1,000 December 7 calls for the ask price of $1.60, resulting in a debit of $160,000 -- (1.60 * 100) * 1,000 = $160,000. If this were a straightforward call play, the trader would need OREX to rally roughly 52% from Friday's close at $5.67, to $8.60 per share, in order for the position to reach breakeven at expiration. Furthermore, the maximum loss on this leg of the position is limited to the initial investment of $160,000.

As you can see, the second leg of the debit spread helps to offset the cost of the overall position. In this case, the trader sold 1,000 December 10 calls for the bid price of $0.85, netting a total credit of $85,000 -- (0.85 * 100) * 1,000 = $85,000. Combining this leg of the trade with the purchased December 7 call lowers the total cost of the entire position to $75,000 -- $160,000 - $85,000 = $75,000.

OREX vertical call spread details

The maximum profit is calculated by subtracting the initial net debit of $0.75 from the difference between the two strikes, and is reached if OREX rallies to $10 per share at expiration. In this case, the maximum profit is $2.25 -- (10 - 7) - 0.75 = $2.25 -- or $225 per pair of contracts. The maximum loss is equal to the net debit of $0.75, or $75 per pair of contracts. Below is a chart for a rough visual representation of the trade's profit/loss scenario:

OREX vertical call spread profit/loss chart

Implied Volatility

After the vertical call spread has been entered, changes in implied volatility are pretty much neutral to the overall position, as it impacts the value of both the sold option and the purchased option. At the time of the trade, implieds for the December 7 call arrived at 323%, while the implied volatility for the December 10 call came in at 294%. Both readings appear to be heavily influenced by the company's pending appearance before an FDA panel, as the stock's one-month historical volatility arrives at a mere 60.85%. With implieds bid extremely high, from an historical perspective, there is the potential for volatility to decline sharply after the FDA decision.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options

Referenced Stocks: ARNA , CBOE , OREX , VVUS

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