Trading a Stock, After a Big Gain
It actually happens fairly often. A stock makes a big gain based on news. Then, some traders look elsewhere, thinking they missed the move. That is certainly one approach to take.
But, there is another way to look at the big price move. Some traders may consider it a cue to identify a trade in a stock. That’s the case after a large jump in the price of Arena Pharmaceuticals, Inc. (Nasdaq: ARNA).
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The Reason for the Jump Appears to Be Bullish
The first step after seeing a large price move is to consider the news. As PR Newswire reported,
Arena Pharmaceuticals, Inc. and United Therapeutics Corporation announced that the companies have entered into a global license agreement for Arena’s Phase 3 investigational drug candidate, ralinepag, a next-generation, oral, selective and potent prostacyclin receptor agonist in development for the treatment of pulmonary arterial hypertension (PAH).
Under the terms of the agreement, Arena will grant United Therapeutics exclusive, worldwide rights to develop, manufacture and commercialize ralinepag.
In return, Arena will receive up to $1.2 billion, including an upfront payment of $800 million and potential milestone payments totaling up to $400 million based on the achievement of certain regulatory events.
Additionally, Arena will receive low double-digit tiered royalties on annual net sales of ralinepag.
“We believe ralinepag has the potential to transform the treatment of PAH,” said Amit D. Munshi, President and Chief Executive Officer of Arena.
“We are thrilled to partner with United Therapeutics, based on their long-standing, deep commitment to the PAH community. This transaction represents a significant milestone in the development of ralinepag and will strategically position Arena to aggressively advance our best-in-class pipeline, anchored by etrasimod and olorinab, with the focus and resources essential for long-term success.”
“We are very impressed with the clinical development plan and FDA coordination being managed by Arena,” said Martine Rothblatt, Ph.D., Chairman and Chief Executive Officer of United Therapeutics.
“We have conducted extensive due diligence on ralinepag, applying our two decades of knowledge about PAH.
We are confident that after achieving FDA approval via at least one of its several different potential regulatory pathways to success, this product will help greater than 10,000 patients annually from the 2020s and well into the 2030s, while complementing our existing portfolio of PAH therapies.”
The bottom line is that Arena will receive $800M upfront, and is eligible to receive low double-digit tiered royalties, plus up to $400M in milestone payments.
That’s bullish for the stock. And, it appears to be the end of a recent pullback in the price that was stopped abruptly by this news.
A Trade for Short Term Bulls
As with the ownership of any stock, buying ARNA could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for ARNA
For ARNA, the December 21 options allow a trader to gain exposure to the stock.
A December 21 $43 call option can be bought for about $3.00 and the December 21 $45 call could be sold for about $1.97. This trade would cost $1.03 to open, or $103 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $103.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in ARNA the maximum gain is $0.97 ($45 – $43 = $2.00; $2.00 – $1.03 = $0.97). This represents $97 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $103 to open this trade.
That is a potential gain of about 94% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.