Trading FDA Decisions with Calendar Spreads
Joe Kunkle, The Investment U Research Team
FDA approvals/rejections of drugs can make or break a Biotech company. These decisions can be incredibly volatile and profitable if you’re positioned correctly.
There have been instances where shares lose more than three-fourths of its value and other cases where a company rises 900% or more in a single day (like Vanda Pharmaceuticals recently).
In most instances, it’s pretty clear when the FDA will make a decision on a key drug, often named the PDUFA data.
Also, companies generally make available dates that it will present top line data from drugs, before it submits it to the FDA for approval of an NDA (New Drug Application).
The information on FDA decisions and announcement dates are out there. And many talented investors make a lot of money playing them. However, using options to profit from these explosive situations can give you gains of a much greater magnitude.
So much so, that a trader can be right just 1 out of 5 times but still have a net positive return. So what is the best way to take advantage here? Simple.
One of the best ways to trade FDA decisions is through the use of calendar spreads, buying a call spread if you expect a positive announcement and buying a put spread if you expect a negative reaction. Here’s how you do it and a couple of companies to follow through with.
What is a Calendar Spread?
A calendar spread occurs when you are short (sell) a near month expiration contract, and buy a contract with a later expiration with the same strike price.
Using this technique, you can take advantage of both the impact of volatility rising ahead of the actual news date, and the directional impact of the reaction in price of shares.
You can also limit your exposure by adjusting the trade to a diagonal spread, meaning you could sell an out of the money call option in the front month, and purchase an in the money call option in the further expiration month (same applies to puts).
Here’s a recent example of this strategy in action.
In this case we’re using Acadia Pharma (ACAD), to execute a 1,000 contract calendar call spread. A trader sells the August $2.50 calls for $0.35 and buys the September $2.50 calls for $0.75 – a $0.40 debit. Currently the stock sells for around $2.00, so in this transaction the trader is betting on near term range trade with upside movement in September.
The reason why this transaction makes sense is that it’s a long strategy on the performance of ACAD Phase 3 results which are expected in Q3 for Pimavanserin for Parkinson’s disease.
Another example of a calendar spread trade you could make is with a stock like Auxilium Pharma (AUXL). It has an FDA PDUFA date of 9/16 for its key Xiaflex product.
That date falls just two days prior to options expiration which makes the trade even more exciting.
If you expect positive results, as most do for this one, you could sell the August $35 calls for $1 and buy the September $35 calls for $3.20, limiting the net cost of your trade to just $2.20.
The best case scenario is that at the August options expiration, the AUG $35 calls you sold expire worthless with shares below $35. Now you own the September $35 calls at a much lower cost basis, especially if shares rise from current levels around $30.30.
Then, come September, a positive reaction to the FDA decision could send shares above $40, resulting in an easy double on your initial outlay.
As with any strategy there are risks to be aware of, as the decision could go against you, but at least with this method you limit the initial cost of have your exposure either long or short, by selling a front month contract.
This is a strategy you can use on a number of Biotech stocks, and is worth a look for anyone interested in speculative Biotech and/or options trading.