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How To Trade Peregrine Pharma's Lung Cancer Fiasco

Stocks in this article: PPHM

NEW YORK ( TheStreet) -- Peregrine Pharmaceuticals (PPHM - Get Report) shares plummeted more than 80% last week on news that the company found major discrepancies with the Phase II trial of their non-small cell lung cancer drug candidate bavituximab. Making matters worse, the event triggered a material adverse change clause in the company's credit facility thus requiring immediate repayment of $15 million plus interest and fees.

Peregrine stated that due to these changes they have sufficient liquidity to fund operations until April 30, the end of its fiscal year. The cold, hard truth is that the company needs to raise more money and time is running out.

Peregrine shares closed Friday at $1.03.

Even with these serious challenges, Peregrine shares have managed to remain above $1 (the stock closed Friday at $1.03) and I don't expect the stock price to plunge below 50 cents in the near term. Shorting Peregrine shares outright is difficult because they are hard to borrow. In addition, buying the Puts at 35 cents is likely a losing proposition on a risk/reward basis i.e. risking $1 to make $1, the shares need to drop to 30 cents by expiration. I don't see that happening, although I could be wrong.

An alternative approach to trading Peregrine with a short bias is to use both puts and calls. Try the following trade:

Buy 20 JAN13 1.0 strike Puts @ 0.35 = $700
Sell (30) JAN13 2.5 strike Calls @ 0.25 = $(750)
Initial Trade P&L = $(50) Credit

P&L Diagram:

In this trade, I am buying Puts fully financed by selling a higher ratio of Calls. The trade can be done for a small credit of $50 excluding commissions. This structure allows the premium decay in the long Puts to be offset by the premium decay in the short Calls -- it thus protects against the situation where the stock trades around $1 for extended periods of time. It also provides immediate and increasing profit at all points below $1 (where buying the $1 strike Puts outright needed the shares to trade to 65 cents just to break even.)

Due to the enormous challenges Peregrine faces, I don't see the shares trading above $2.50 by January expiration, hence I am willing to sell those Calls at a higher ratio. The risk in the trade is that it includes naked Calls (the Calls that were sold) -- this needs to be understood as it is very important from a risk perspective. If Peregrine shares trade higher than $2.50 by the January 13 expiration, this trade loses money. Losses in this trade could be enormous if Peregrine shares trade to recent highs of $5, but this is a very low-probability scenario given recent events.

Pelz has no position in Peregrine.

To learn more about using options to trade biotech stocks, check out Tony Pelz's book, The Biotech Trader Handbook or subscribe to Chimera Research Group.

Tony Pelz was a trader on a major European bank's proprietary trading desk, responsible for a portfolio with limits of more than $200 million. Prior to proprietary trading, Pelz worked with several global investment banks in roles ranging from corporate finance, M&A to credit and business development. He is author of The Biotech Trader Handbook, 2nd Edition, co-founder of the small-cap biotech research and trading site Chimera Research Group and operator of PelzOptions.com. Pelz currently resides in Denver, Colorado where he trades for his own account.

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