TIP SHEET: McMillan Likes Options Of Small-Cap Pharma Stocks

NEW YORK (Dow Jones)--Pharmaceutical stocks typically make big moves when drug companies release news about their products. Options guru Larry McMillan and other options traders have found ways to profit from those big swings.

As founder of McMillan Analysis Corp. in Morristown, N.J., an advisory firm that manages $18 million on behalf of individuals seeking exposure to options, McMillan suggests investors adopt a "straddle position" in pharmaceutical companies poised to release news about drugs they have in the pipeline.

By adopting a "straddle" in the company's options, investors can profit from swings the stock makes in either direction, McMillan said. That is key because pharma stocks can soar when companies secure approval from the U.S. Food and Drug Administration or achieve favorable trial results, but they will also tank when they don't.

The straddle involves buying a call option, which allows them to buy stock at a predetermined price, and also a put option that allows them to sell stock at the same price. The cost of the position equals the combined cost of the call and the put. It makes money once the underlying stock moves, either up or down, more than the cost of the trade.

Recently, McMillan suggested his clients pursue a straddle in Pozen Inc. (POZN), a drug company that was expecting to hear back from the FDA on its migraine drug Treximet. On April 10, with Pozen shares closing the day at $10.30, he recommended buying May $10 calls and May $10 puts for a straddle that cost a total of $5.

On April 13, three days later, the strategy started to make sense as the FDA announced it had approved the drug, pushing Pozen shares 31% higher than the April 10 closing price, to $13.50. The stock has to move to $15 before May before the strategy makes money.

"The stocks gap so far on the announcement that you can profit from owning the straddle," McMillan said. "We've done studies in the past and there's a positive expected return by doing this."

The straddle, when used in options of pharma companies, generates an average net return of 18%, McMillan said.

Among the companies awaiting FDA approval for their drugs - and that make good candidates for a straddle - are CV Therapeutics, Progenics Pharmaceuticals Inc. and Shire Pharmaceuticals Group Plc. Among companies that are awaiting the results of their own trials - and also make good bets - are Acorda Therapeutics Inc. (ACOR), Auxilium Pharmaceuticals Inc. (AUXL) and GTx Inc. (GTXI).

Investors can sometimes achieve better results when the companies announce negative rather than positive results. That is especially true for small companies, whose value is tied up with the success of one drug and therefore take bigger hits when their products fail to secure approval.

Pozen, for example, with a market cap of $390 million, had initially sought FDA approval for Treximet last summer. But when the federal agency delayed its decision, the stock dropped 43% in one day.

While small-capitalization stocks can move dramatically on such news, larger companies rarely do. That is why McMillan suggests investors steer clear of big names like Merck & Co. Inc. (MRK), Pfizer Inc. (PFE) or Genentech Inc. (DNA).

He warned, however, that it is tough to pin down the timing of FDA hearings or drug trials, making it especially difficult to trade options around those events. Since options expire every month, the market tries to guess at probable dates by assigning higher volatility ratings and higher prices to contracts in certain months. As a result, McMillan suggests investors try to increase their odds of success by taking advantage of market intelligence and buying expensive options.

In cases where the timing is more clear, McMillan says investors should attempt to execute their trades as close as possible to those dates. Because straddle positions make money if the stock moves up or down from a benchmark - the current share price - investors should position themselves in options with strike prices that are close to current share prices.

Like any trading strategy, the straddle involves risks, most of it associated with timing. If the FDA delays its approval of a drug, or a company pushes back a drug trial, investors who bought options in anticipation of these events occurring at a specific time could see their contracts expire worthless.

(Tennille Tracy covers the options market for Dow Jones Newswires.)

-By Tennille Tracy, Dow Jones Newswires; 201-938-2345; tennille.tracy@dowjones.com

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