HGSI: Stock Up, Calls Down? How?

On Friday night I did a video about the excessive volume in Human Genome Sciences (HGSI).

More than 200,000 options traded Friday, October 30, 2009, due to a pending release of results around their Lupus drugs. Bloomberg wrote an article noting that JP Morgan had been telling customers to buy bullish options ahead of the results. They felt there was a 70% chance of a successful outcome.

Well, they were right. The stock was up 35% Monday from $18.69 to $25.28. Let’s look at the performance of the November calls (I assume these are the so-called bullish options). Now to be fair, I do not know when JP Morgan made the call, and where the options were trading at that time. I will just use the closing prices from Friday and Monday.

Okay, so the stock outperformed all of these calls on a return basis. So much for the “leverage of options”: Unless you bought options with a very high premium and delta, you may have lost money buying calls on a 35% up move. That is less than intuitive. All the calls listed above actually ended Monday’s trading in-the-money.

Well, the market is not stupid. Because of the magnitude of this event, implied volatility was really high. If you wanted to buy these calls, you really had to pay high premiums for them. Now the real question is what would have happened if the results were bad. All of these options would have lost a huge percentage of their premium with a down move. It makes the calls seem really risky, unless the stock would have declined more than 30%. My guess is that it would have with a negative result.

A strategy that could have been employed in this case may have been a buy/write. This is a strategy that consists of buying the stock and simultaneously overwriting an upside call. The high premiums of the calls would have provided a downside hedge, if the results were negative, while still providing compelling returns to the upside. Now granted, we have the benefit of hindsight here, but let’s continue the exercise to learn for future events.

If you were bullish on the event as JP Morgan recommended, buying the stock at $18.69 and overwriting the 22 calls at $2.95 would have a downside hedge to $15.74, or 15.7%. The maximum profit is capped above 22 in the stock, however, though adding the call premium to the upside in the shares provided a total return of $6.26 or 33.5%. Strike – stock + call premium (22 – $18.69 + $2.95 = $6.26 ).

The risk to a buy/write is having your stock called away at strike, potentially limiting your upside gain. Of course the more significant risk is if the stock price falls, the maximum potential loss is the total dollar amount paid out. The stock price less the amount received on the short call.