Case for Buying Eli Lilly Calls
By TENNILLE TRACY
June 4, 2008
The U.S. Food and Drug Administration is expected to issue a decision on Eli Lilly & Co.'s new antiblood clot medicine this month and some experts suggest buying the drug company's options before an announcement is made.
According to a recent report published by Credit Suisse, Eli Lilly's new Prasugrel drug is more effective than similar medicines on the market and there is a 60% chance the FDA approves the drug when it issues its decision June 26.
Despite the favorable odds Credit Suisse gives to FDA approval, the options market has assigned a relatively cheap value to call contracts that convey the right to buy Eli Lilly's stock. That presents a trading opportunity, said Sveinn Palsson, an equity derivatives strategist with Credit Suisse.
Looking at the "skew" in Eli Lilly options, Mr. Palsson found the implied volatility of put contracts, which convey the right to sell the stock, is higher than that of the calls. While this is typical in most cases, since investors are more inclined to buy puts to protect their stock against downward moves, the skew suggests the market hasn't factored in the likelihood of FDA approval.
"When you have a big binary catalyst [like FDA approval for a drug] and people consider the upside risk to be substantial, then you'll see the skew change, get inverted, or flatten out. In this case, the skew looks normal," Mr. Palsson said.
Options traders might be able to take advantage of the situation by buying July $50 calls and then selling July $45 puts to help offset the cost of the calls. The position costs 50 cents and makes money if Eli Lilly shares climb above $50.50. Eli Lilly's shares rose 69 cents, or 1.5%, to $48.28 in New York Stock Exchange composite trading at 4 p.m.
Eli Lilly's stock could jump considerably if the FDA signs off on Prasugrel, especially since the drug could generate $1.5 billion in global sales by 2012, Credit Suisse says. However, the options strategy does carry certain risks. If the FDA declines approval, then Eli Lilly's stock is likely to drop. That means the calls could expire worthless and investors, being short the puts, might be forced to buy them back at higher premiums or even buy the stock at unfavorable prices.
Options traders frequently take positions in pharmaceutical companies awaiting FDA approval, given the impact such decisions have on stock prices. On Tuesday, for example, options traders flocked to Indevus Pharmaceuticals Inc., driving the daily trading volume to 15 times the normal level.
With Indevus awaiting approval for its Nebido drug, options traders appeared bearish on the company and bought July $2.50 puts. Priced at 25 cents, the contracts make money if Indevus shares drop below $2.25. Indevus fell 30 cents, or 6.8%, to $4.10 in 4 p.m. Nasdaq composite trading.
Over the course of the session, 63% of the trading activity implied a bearish sentiment and 32% implied bullish, according to Trade Alert. The remainder fell somewhere in between.
online.wsj.com |
