Tuesday, July 5, 2011

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Wednesday, November 25, 2009

Biotech Stocks - Beware of The Covered Call Trap

Years ago when I worked in retail brokerage, I knew a broker at another firm, who specialized in pitching covered call plays. He would explain to clients how with covered calls you take your profits upfront and the premium you just collected gives you a nice cushion to the downside. Say you buy stock ABC at $10 and sell the $10.00 strike calls for next month at $2.00. If the stock price at expiration is at or above $10, your calls are assigned at $10 - you break even on the stock, and you keep your $2 premium for each of the calls, for a 20% profit. Even if ABC is down a bit, say at $9.50 at expiration, you still make money. The calls expire worthless, you are down $.50 on your ABC, but you still have your $2.00 from the call you sold, so your profit is $1.50 and you get to sell the calls against your ABC again next month. The only way you can lose money is if the stock is down more than the $2.00 per share you collected for each call. My fellow broker would promise clients to minimize a potential loss by putting a stop loss order for ABC at $9.00 and buy the depreciated calls back if the stock ever dropped to that level.

Sounds like a good plan right ? I mean, how can you lose ? With the calls yielding 15% or 20% per month and minimum downside risk, this broker looked like a market genius signing up several new clients every day. Unfortunately, back then and to this day, there is no free lunch in the market and stocks that have high-yield calls are always the stocks with very high price volatility. The broker would pick the stocks with the most expensive calls, not bothering with what the companies actually did, because he "knew" he can always sell them if the price dropped 5-10%. By this method, his clients often ended up owning biotech stocks, which as an industry are not only some of the most volatile, but the absolute worse for selling covered calls against.

I know of no other industry, where a single announcement could literally make or break a company. An FDA decision or the results of a pivotal experimental drug study routinely cause 50% moves in either direction. And since these announcements are usually made pre-market or after the market close, your $9 stop loss order will kick in when the market opens the next day, and your stock is already down from $10 to $5. Of course, you have to buy the calls back first before you sell your ABC at $5, otherwise you'd have the calls naked. Hopefully by the time you close your call position, the stock ABC has not dropped further down to $4. Yes you still have $2 profit on the call, but you just lost $6 on the stock, so overall you're down $4 or 40%. Of course if you had bought ABC on margin, you just lost 80% of your investment.

Selling covered calls against biotech stocks was a recipe for disaster then and it remains so today. Below are 3 recent examples, that devastated the covered call sellers.

Take a look at Poniard (PARD) which was trading around $7.00 all day on October 27. The December $7.50 calls were selling at $2.50. The calls yielded 36% over less than 2 months !!!! However this supposed boon for covered call sellers, turned into a bust when PARD opened at $1.77 on November 16th (down from $7.58 at the close of the previous day). The $2.50 call premiums collected, were small consolation for the $5.23 ($7.00 - $1.77) loss on the stock.

Or let's say you bought Osiris (OSIR) at $14.50 on September 02, and sold the Sept $15 calls for $2.50. Wow, that's 17% yield in 2 weeks ! However, just 6 day later, on September 8, OSIR opened at $7.40....That's a $7.10 loss on the stock (less the $2.50 you made on the calls) a loss of $4.60 or 32%.

And here is another - GTX Inc (GTXI) traded around $12.50 on September 21. One of the bests calls to sell was the November $15.00 which was selling for $2.80. Just 10 days later, the stock opened at $5.80 on November 2nd, a $6.70 loss on the equity for those who bought the stock at $12.50 (less their profit of $2.80 on the call of course).

In the above examples I have quoted the opening prices the days the stocks collapsed as these were not gradual declines over several days giving investor a chance to get out, but overnight changes of value, that could not be avoided even if you had a stop loss order in place or were watching every tick in the price during market hours.

Covered calls is a conservative strategy and in fact is the only use of options allowed in IRA accounts, but could bring disaster when not used wisely. Limit your covered call selling only to blue chip companies, that you already own. These calls will yield 1-2%, but stock price declines tend to be small and gradual, giving you plenty of time to take a small loss and get out. Don't be tempted by the expensive calls of risky companies, and NEVER sell covered calls on Biotechs.

Disclosure: The author purchased $2.50 calls on PARD after it collapsed to its current levels.

Tuesday, November 24, 2009

PARD - Azimuth Opportunity Bets on Poniard's Survival. Should you ?

I was poring over Poniard Pharmaceuticals' past press releases and financial reports this weekend, wondering how close this Biotech really was to shutting its doors forever. Things certainly did not look rosy.

Last Monday, November 16 the company had announced that the pivotal Phase 3 trial of its lead drug Picoplatin on relapsed and progressing cases of Small Cell Lung Cancer (S.C.L.C.) had failed to meet primary endpoint. The news cause the stock to open at $1.77, down form a close of $7.58 on Friday, wiping out 77% of the company's market cap in the blink of an eye. The next day, it bounced back by 35%, closing at $2.48 on positive news for the drug's Phase 2 Trials in the treatment of colorectal cancer - a nice pop, but hardly a consolation for those investors owning the stock at $7 or $8.

Devastating news are common in the Biotech industry, but what made the story much worse is the company's financial condition, creating serious doubt whether Poniard will be able to fund the drug's upcoming trials. The company reported cash and marketable securities totaling $40 million at the end of the September quarter. PARD has an $18 million loan on its books that requires the company to maintain cash reserves at least equal to the outstanding balance on the loan. Total expenses for last quarter were approximately $10 mln, a $2 mln decrease from same quarter last year, and expected to decrease further as the testing of Picoplatin is now in its final stages. The company has no revenues and no approved drugs selling in the market.

It is common for small biotechs to partner up with established pharmaceutical giants for the development of a specific drug. The larger partner would help fund the studies and FDA approval expenses in exchange for the lion's share of the profits if the drug is approved. However, so far Poniard had been unwilling or unable to enter a partnership for Picoplatin. Analysts speculated that CEO Jerry McMahon was waiting for the results of the pivotal Phase 3 trial in Small Cell Lung Cancer, to put Poniard in a stronger negotiating position in a potential partnership agreement.

As I saw it, while researching PARD this weekend, the small biotech found itself with a major setback in its Picoplatin experimental trials, no funding partner, and hardly any cash to continue the studies on its own. I consider this very unfortunate as the drug Picoplatin is not without potential.

Picoplatin is currently in Phase 2 studies for Colorectal Cancer and Metastatic Prostate Cancer. As Tuesday's press release on colorectal cancer studies showed, Picoplatin's efficacy is comparable to that of commercially available drug Oxaliplatin, with much less side effects. Seven patients who were on oxaliplatin, chose to discontinue the study due to neuropathy vs. zero patients taking picoplatin. If picoplatin is safer than an already approved drug, then chances for its own approval seem pretty good. Of course, before PARD can file the NDA (New Drug Application), a Phase 3 trial will need to be completed on a much larger patient population, and safety and efficacy further evaluated. And here is where Poniard's cash shortage comes in to put a wrench in the works.

Then this Monday, November 23 Poniard announced it will be able to tap its existing equity financing facility and raise $7.4 mln through the sale of 3.5 million shares at the discount price of $2.15 to Azimuth Opportunity. Azimuth has bought minority stakes in numerous development stage biotechs in the past. These registered stock deals are similar to PIPEs, or private investment in public equity, and allow the companies to avoid the time consuming and sometimes pricier route of secondary public offering. While investors were aware of this funding option, where PARD can sell up to 60 million shares to Azimuth as long as the stock price is not below $3, the current depressed stock price made accessing the financing seem impossible. Azimuth's purchase of Poniard's stock will allow PARD to fund its clinical trials and business operations through mid-2010, CEO McMahon said.

While the sale obviously dilutes shareholder equity by increasing the float by appoximately 10% and has a short term negative effect on the price, it is a relief for Poniard's long term investors. It buys PARD more time at a crucial moment, when many like myself wondered if all is lost.

As expected when a company sells new stock below the market price, the PARD has slid from the open of $2.50 on Monday to the levels of Azimuth's discounted purchase price of $2.15 today. I expect it to remain in the $2.15-$2.20 range for the next few days. If the stock holds the $2.15 support level, it will be seen as a positive sign. Short of additional positive news, appreciation will be a somewhat uphill battle in the next couple of weeks, as Azimuth will be looking to book some profit from its investment and sell some of its just purchased PARD stock into rallies. However this profit taking will not hold the price down for too long, as the investor's 3.5 mln shares can be easily drowned in a good news day such as last Tuesday, November 17th when near 36 mln shares traded pushing the price 35% higher.

And really, a lot can and will happen with Poniard in the next 6 months. A positive event such as securing a new line of credit, entering a partnership agreement for Picoplatin, a takeover announcement or continued positive results from the clinical studies can each send the stock flying. Of course, another major clinical results disappointment, can make securing any new financing out of the question, so certainly Poniard's executives have not a minute to waste.

So is there a play here ? Investors, not opposed to the occasional small-stakes speculation can buy the stock here and ride the swings with Poniard. I think it is very likely we will see PARD at $2.50 or even $3.00 within a month or two even without major positive news. At this point, you would be smart to take profit on 1/2 or 2/3 of your position. Reversely, a drop below $2 without any actual negative news would signal a very bearish short-term view of PARD, and you should protect yourself by putting your Stop Loss at the $2.00 level.

Personally, I'm somewhat bullish on PARD short term, and believe in this case options provide a better risk/reward than owning the stock. I bought the December 2.50 calls, which are selling for $.20 today. A $.35 move of the underlying PARD back to the $2.50 level, will value the calls at .$50 (ask) - (delta is .83), with the bid at $.40, giving me 100% gain. At that point my plan is to sell 2/3 of my calls. I will likely leave about a third of my calls open as a sort of a free lottery ticket, in case of a positive announcement by the company. I'd give it a better than 50/50 chance I'd double my money with the calls and maybe a 5% or less chance of 300% or 400% gains.

In addition, I sold the March $2.50 puts at $1.00. This is my bet that PARD will still be around, come the spring, which now with the funds raised through the equity sale seems more than likely. Even in the absense of major news, if PARD remains at current levels in the next few months, note that the price of the put today consists of $.65 time value, which will slowly erode down to nothing by expiration. So whether the stock is up or unchanged in 3 months, I will be profitable. Selling naked puts is often described as almost as risky as naked calls, as the stock can potentially go down to zero, at which point the put buyer will sell a worthless stock to me that I must buy at $2.50. However I will buy the puts back quickly for a 10-15% loss if the stock breaks below $2.00, as I have no intention of riding PARD down to zero in the unlikely event that the stock price deteriorates further from the current fire-sale price levels.

Remember that the above described option positions are high-risk plays and you may lose you entire investment in them. Do not risk more than 5% of your portfolio in all speculative positions such as these combined.

Disclosure: The author is long the December $2.50 calls and short the March $2.50 puts.