What's Gone Wrong

I'm looking at live video of the restless masses forming in London to greet the G-20 members and I'm thinking this is a microcosm of what's going on worldwide--not just apathy against globalization and banking, but outright anger against capitalism. This is a bad omen on equities and risk capital, in general. We officially now have blood on the streets for the world to see. This is only the beginning, in my opinion.

Buyers of Arena Pharmaceuticals shares took a bath, despite good results in the phase III clinical trials. Lorcaserin, the obesity drug with huge potential, met all FDA end point guidelines regarding efficacy and safety, yet the market punished its stoct because apparently, it wasn't enough to satisfy analysts with poor understanding of the biochemistry behind it. Two years ago, when risking capital was in vogue, the share price of this drug soars from $4.50 to $25 on this good news. Instead, it dropped to $3.

With investing, one has to be grounded with reality--intellectual honesty is fine, but one has to play the cards one is dealt. The price is what it is--no time to play coulda shoulda woulda. Lorcaserin should be approved and this should drive its share price up, whether it's via a co-marketing agreement or an outright buy out offer by a big pharmaceutical company looking to bolster its depleting drug pipeline, as more and more blockbusters go off-patent, impacting profit margins.

So here I am, sitting on losses of 25% to 50%, depending on my entry points. What to do? Two things I plan on doing:

1) Sell covered calls - for each 100 shares owned of ARNA, sell 1 covered call option at a strike price of $5 and as far out in expiration as I can stand to hold on to the stock. The further out expiration month I sell, the more premium I collect. This should completely or partially offset any losses from this trade. This strategy will allow me to collect the premium upfront, irrespective of the direction of ARNA shares. And if ARNA stays at or below $5 during this expiration period, I keep the premium no matter what, and the call option I sold expires worthless--good for me, bad for the option buyer. If ARNA soars above 5, my call will be exercised, meaning I sell my shares at $5, and I still kept my premium. This limits my upside, but that also means I made a 67% profit from selling my shares at $5, PLUS I still kept my premium. This gives me a profitable exit strategy as well as a great hedging opportunity. The only way I lose is if the stock goes down further, but again, I still kept the premium, so it reduces my losses. Covered calls are a way to increase my income while reducing my downside. Just remember to stay covered: I will not write (sell) more call options than I have actual underlying shares. 1 call option contract= 100 shares of underlying stock. In other words, if I own 1000 shares of ARNA, I will sell 10 call option contracts, as each options contract obligates me the right to sell 100 shares at that strike price.

2) To further reduce my downside, I can also buy put options, betting on a further decline in ARNA share prices. But now I have to pay the premium to the put option seller, and now I can lose that premium if the stock doesn't decline. In other words, now I am the casino player--instead of the casino as I was in a covered call. But it protects my position, in case ARNA runs out of cash and drops to $1 or zero, for instance. The value of the put option increases as the share price decreases, so I can profit from the put in the case of the decline in share price. This strategy requires cash outlay, but it gives me leverage and protects me from catastrophe.

As a shareholder, the covered call strategy really has no downside, and only limits my upside. The put options have some downside, because the options can expire worthless whether ARNA stays constant or increases in price (which is a good thing as my underlying stock value rises). A put option is insurance, albeit carries a premium. By contrast, selling a call option makes me the insurer, as I collect the premium. So definitely sell a covered call, and possibly buy put options. Both buying and selling options requires an upgrade one's account, so one has to apply or contact the broker. One needs the ability to write covered calls, and to buy call and put options.

ARNA could have a nice run, and the profits will come in long-term as big pharma should see value in Lorcaserin. But this market is so skittish that if no offer for a buy out or partnership agreement comes through, we as shareholders need to protect ourselves. And if the stock price does rise, we can also participate on the upside. The covered call is a sure way to hedge, while the put option COULD be a great hedge, but also costly--I could lose 100% of my premium upon expiration. As a minimum, one should utilize covered calls. Depending on how pessimistic I am with ARNA, I may or may not buy put options. I could also do both, as the premiums I collect on the covered call can offset the premiums I pay for the put option.

Disclosure: I own shares of ARNA. This is not a recommendation, and do your own diligence. While covered calls are a conservative strategy of increasing income, the downside is that the price of the underlying stock could decline. Put options are inherently risky because one can lose 100% of the premium on expiration.