) --

Ziopharm Oncology

(ZIOP) - Get Report

is expected to announce high-stakes results from a phase III study of the company's cancer drug palifosfamide in the fourth quarter. With this all-important catalyst approaching, it's been interested to see very aggressive Call buying over the past few weeks. Large traders have been taking positions in Ziopharm in advance of the palifosfamide data with expectations to profit from either a large upside move in the stock price or outsized increase in volatility.

Despite this, short interest is quite high at around 17% and the company is rapidly burning cash. (Cash per share, a useful metric for gauging potential downside from a failed drug trial, is at $1.40 as of June 30.)

This is a high-risk catalyst for Ziopharma: Buying or shorting the stock is simply too risky as there is no way to control one's maximum risk. Positive or negative data will result in an immediate re-pricing of the stock, thus there is no way to define or limit risk being long or short the shares. Using options, however, risk can be defined and limited at the outset - you know with certainty the maximum loss going into the trade.

For this trade I will be using a bullish approach. The trade is quite simple:

Buy 10 JAN 5.0 strike Calls at 0.95 = $950

Initial P&L = $950 debit

This trade costs $950 -- also the maximum potential loss. The stock needs to trade above $5.95 by JAN expiration (January 19, 2013) to break-even (options currently imply an up or down move of over $2.) Alternatively, profit can be made if there is a large increase in volatility. Under this scenario, the option premium could increase enough to sell the Calls at a profit. Often implied volatility in these catalysts can more than double (even triple) thus making this type of trade possible.

In practice, capturing profit using this approach is difficult because we don't know exactly when Ziopharm will announce the study results. Bid/ask spreads are very wide, thus eating up a lot of the gains if you decide to exit.

Pelz has no position in Ziopharm Oncology.

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

. Pelz currently resides in Denver, Colorado where he trades for his own account.