Tuesday, December 7, 2010

OREX - Creating the Reverse Synthetic Convertible.

OREX's Contrave is set to be heard today by another FDA panel to discuss the drug's efficacy.
December 7, 2010 Endocrinologic and Metabolic Drugs Advisory Committee
Meeting - Webcast Information

The FDA plans to provide a live webcast of the December 7, 2010 meeting of the
Endocrinologic and Metabolic Drugs Advisory Committee.

Please note that the webcast will not display until the meeting begins at 8:00 a.m. EST on
December 7, 2010.

The webcast can be accessed here: https://collaboration.fda.gov/emdac/

I previously created a new design on the synthetic convertible that is an ideal play for this type of trade.    Again, necessity is the mother of all invention because my broker would not allow me to short OREX so I was forced to create the reverse synthetic convertible.

The reverse synthetic convertible is essentially the same play with OTC options with a long position in the stock versus a short.   This allows us to bypass the fact that we may not be able to short some stocks or ETF's and can also allow you to use your IRA to create some positions.   So let's create the trade from here.

We know that some volatility has been created with this news so it makes a great play  for my strategy.   So here is the trade (Reverse Synthetic Convertible)
     Short 20 Jan 11 OREX $7.50 Calls ($1.75 Avg)
     Long 1,000 OREX Stock ($5.43 Avg.)
     Long 7 Dec. OREX $3 Puts ($0.55 Avg.)

These trades were initiated on and around the 19th of November so the prices are somewhat different than today's information.    As you will also notice the difference in the Reverse and the normal Synthetic Convertible is simply the reverse of the original trade.   This makes complete sense because again remember that we are creating a new instrument and reversing the trades creates the same profile just in a different format.    The only changes that I have made to the original trades were sells of my original long (around 1,200 shares) to correspond with the appropriate delta on the call.   These trades allow me to create a better hedge and be in a better position when the event comes along.


Monday, December 6, 2010

HGSI Synthetic Convertible - The Perfect Trade (In Jeopardy?)

On Friday afternoon the FDA released notice that they were now delaying for 3 months their ruling on the approval of HGSI's lupus drug.   From my standpoint the approval or non-approval is not important.   What is important to me is the actual "event".    The "Perfect Trade" is somewhat hinged on the event itself and in no way reliant on the actual yes/no approval.    So does the delay itself actually derail the perfect trade?   The answer in short is "No".  

Please remember that we set the "Perfect Trade" in the following manner.
     Long 10 December $23 Calls ($2.80)
     Short 700 Shares HGSI ($24.90)
     Short 5 December $22 Puts ($0.75)

So let's retrace and analyze the options that we have at this point.    With the announcement of the delay in the FDA approval shares of HGSI immediately plummeted and it looked as though the market was adjusting the price accordingly.   Today however the price rebounding and at one point was actually higher but could not hang on and finished down for the down (HGSI $25.27).  

So let's assume that the price stays at this level - what does that do to our perfect trade?   We will still reap the $375 put premium regardless of the finishing price of HGSI.   If the price of HGSI were to stay at these levels we would lose the time value ($0.90) of the call options however would retain the intrinsic value by converting the calls to shares.   We could have the respective profit/loss from the short sale position.   

At today's closing price of $25.27, our "Perfect Tradeis essentially a draw.   If the options were to expire today we would have a losing position of ($414).  

At this point I think that it is still best to ride this trade out and capture some gamma from trading HGSI as the hedge against the call.   We have found the "worst case scenario creates a very small loss with essentially no gain.   At this point we can actively trade HGSI to make up the small loss on the options.



Saturday, December 4, 2010

HGSI Synthetic Convertible - Part 2

After my most recent post with the same title I received a very insightful comment with a question related to the trade on HGSI.   The question was "If there is a non-event for HGSI related to the December 9th FDA panel on HGSI's lupus drug or the meeting is postponed, will that not leave the "Perfect Trade" with a loss?"  Would we not simply lose the premium for the call option with no offset? The short answer to this question is Yes.   Let me explain.

The trade itself is set up for an "event" - the upcoming FDA meeting on the 12/9.   If there was no such  large event upcoming for a particular company then the "perfect trade" would be set up differently.   

Given a stock that is just plain volatile, like some other equities ETF's, the trade would be set up with a longer call option.   The premium outlay on the call option could then be offset for the most part by the steady stream of income from the short puts - if the stock price fails to exhibit the same levels of volatility.   If HGSI would continue to show the same volatility in stock prices then we would simply replace the short call (December) with a longer dated one (June/July).    This set up is much better suited for any equity or ETF that might have good consistent volatility versus the "event" scenario.

A very good actionable and long term trade would be to utilize the small cap ETF's (TNA. TZA etc).   Create the trade so that we can reap the benefits of the volatility however ensure that we can offset the premium outlay for the calls if the volatility goals are not met.   So here is an actionable trade to consider using the Small Cap 3X Leverage ETF (TNA).

     Long 10 Apr 11 $60 Calls ($14.20)
     Short 660 Shares TNA ($64.89)
     Short 4 Dec 10 $61 Puts ($1.60)

This trade will allow you to capture the volatility in the stock by trading the hedged short positions but will also allow the opportunity to offset the call premium OVER TIME with the income stream created by the monthly income from the short put positions.   

Great comment from "Animal".


Sunday, November 28, 2010

The Perfect Trade? HGSI Synthetic Convertible Trade

At this point we are all aware that any upcoming potential FDA approval for pharma companies creates volatility in prices.   At this point we are ready to use this characteristic to utilize the synthetic convertible bond trade that I have been discussing.  

As I mentioned in other posts as traders we are not necessarily concerned with whether the FDA approves a drug or not however we could use this event as a great trading catalyst.   In other posts I outlined the trade profiles that we will need to put on in order to make this scenario work in our favor.   Remember however we are not trying to "guess" on the direction of the stock price swing - simply using a neutral position.   Also remember that in order to use this trading strategy you will need a margin account and the broker's authorization to short stock.

HGSI is set for a FDA hearing for potential approval for their trial drug for lupus on December 9th.   This will provide the landscape and here are the trades:

     Long Dec. $23 Calls ($2.80 Mid Bid/Ask) - 10 Contracts
     Short HGSI Stock - 700 Shares
     Short Dec. $22 Puts ($0.75 Mid Bid/Ask) - 5 Contracts

There is an extremely high probability that on or around the announcement on the 9th of December that the price of HGSI will move in one direction or another.   I have outlined the potential prices of HGSI and the estimated values of each of these positions given the appropriate move in stock price.

At a price of $22 the value of our short positions increases by $2,030, our long call positions fall by $2,000 however we still receive the premium for the short puts at $375.   The net profit is $405.

At a price of $20 the value of our short positions increases by $2,430, our long call positions fall by $2,630 however we still receive the premium for the short puts at $375The net profit is $175.  (I am taking into account that at $20 we will have our puts exercised against use thus reducing our short position to the equivalent of 200 shares).

At a price of $17 the value of our short positions increases by $3,030, our long call positions have max loss of $2,800 however we still receive the premium for the short puts at $375The net profit is $605.  (Still taking into account that our puts will be exercised against use thus reducing our short position to the equivalent of 200 shares)

Now let's take a look at the other end of the spectrum.

At a price of $27 the value of our short positions decreases by $1,470, our long call positions increase by $1,350 however we still receive the premium for the short puts at $375The net profit is $255.

At a price of $30 the value of our short positions decrease by $3,570, our long call positions increase by $4,300 however we still receive the premium for the short puts at $375The net profit is $1,050.

At a price of $32 the value of our short positions decrease by $5,670, our long call positions increase by $7,300 however we still receive the premium for the short puts at $375. The net profit is $2,005.

I imagine that at this point we can start to see the picture of what we are trying to accomplish with my strategy.    I am not trying to predict the direction of the stock moves, I am simply looking for stocks that have upcoming event that create volatility in the stock price.  


Tuesday, November 23, 2010

Synthetic Convertible Guy

Well it is the close of the trading day on Tuesday (11/23/2010) and I have been trading pretty actively over the last several sessions.   I am very happy with the success that my strategy has produced and I am confident that the trend will continue into the foreseeable future.   

I have made several changes to my portfolio including some adjustments to old positions and I have even moved forward into some other very interesting positions.    I think that most of these positions are still "low hanging fruit" for this complex strategy but walk before we run!   The complexities of this strategy can be morphed into futures, international equities, ETF's and so on.

Here is the way that my portfolio is looking right now:
     HGSI ($24.70) - Long Apr $25 Calls, short HGSI stock and then short Dec $23 and $22 Puts
     HRBN ($15.23) - Long Mar $20 Calls, short HRBN stock and then short Dec $15 Puts
     OREX ($5.90) - Short Jan $7.5 Calls, long OREX stock and long $3 Puts
     REGN ($29.99) - Long Feb $27 Calls, short REGN stock and short Dec $29, $24 and $22.5 Puts
     VVUS ($6.21) - Long Mar $5 Calls, short VVUS stock and short Dec $6 Puts

As of the close of business today ALL of my positions were positive thus far and here is a breakdown of the account summary as of close of business today:

Opening Account Value - $200,000
Commissions - ($875.48)
Profit/Loss - $2,388.40

Ending Account Value - $201,512.92

The ending account value represents a HPR (Holding Period Return) of three quarters of a percent in just a few days of trading!!!   VERY EXCITING

Synthetic Convertible Guy

Friday, November 19, 2010

First Day's Trading


The first day's trading is in the books and I am now back to post about the activity.    All in all the overall equity markets went sideways again today with the most major US indices finishing higher for the day.   From my standpoint the fact that volatility fell again today is actually a very good indicator for my type of trading.   

Here is a list of the trades that I put on today.    I will make a spreadsheet available later that you can open and read.
     HGSI - Long April $25 Calls, Short HGSI stock and short Dec $22 Puts
     HRBN - Long March $20 Calls, Short HRBN stock and short Dec $15 Puts
     OREX - Short Jan $7.50 Calls, Long OREX stock and long Dec $3 Puts
     REGN - Long Feb $27 Calls, Short REGN stock and short Dec $22.50 Puts

Most of the positions that I put on today were pretty safe bets, with all these names having some upcoming expected activity or announcement which will create price movements.   

Opening Account Value - $200,000
Commissions - ($429.22)
Profit/Loss - ($249.10)

Ending Account Value - $199,321.68


Thursday, November 18, 2010

Synthetic Convertible Bond Arbitrage - "A Primer"

The concept of synthetic convertible bond arbitrage is based on the traditional hedge fund strategy of what is called "convertible bond arbitrage".   In essence hedge fund managers will purchase a convertible bond and then hedge that fixed income instrument by short selling the underlying equity in a hedged position.  

Taking a step back it is important to understand exactly what a convertible bond really is.    A convertible bond is a fixed income instrument issued typically by a corporation which allows the company to issue debt through tradition fixed income markets and structure an instrument which is unique in its' possible conversion at (or possibly before) maturity.    Typically a fixed income instrument is one which pays a fixed rate of interest per annum and then returns the principal at maturity.   A convertible bond, however similar in structure, allows the company or the purchaser to convert the bond into shares of the company stock in lieu of the principal.   This feature could be very beneficial if the company does very well and the stock increases in price while you own the convertible bond.    If not, the company will still pay the stated interest and principal at maturity.  

Since the convertible has an embedded option to convert the bond into stock, most hedgers will utilize some forms of hedging to allow for downside protection should the stock price fall.   This strategy allows the hedgers to make a profit if the stock rises OR if the stock price falls.    SOUNDS GREAT RIGHT?

THE REAL PROBLEM - The real problem with convertible bonds is that the issuance of these instruments has drastically fallen off in recent years, mostly due to tax changes.    

WHAT IF THE ISSUANCE OF NEW CONVERTIBLES COULD BE REPLICATED?    This is where my strategy comes into play.    Stay tuned for more....