Arena Pharmaceuticals (ARNA) before FDA decision on Wed 6/27/12

Arena Pharmaceuticals (ARNA) shares tumbled Friday, and activity in options shot higher, ahead of a key ruling from the U.S. Food and Drug Administration on the company's weight-loss drug.

  

Options watchers said stock holders were moving into options as a way to play the FDA ruling while limiting risk. A decision is expected Wednesday on the company's weight-loss drug candidate lorcaserin. If given the go-ahead, lorcaserin would be the first prescription diet drug to receive U.S. approval in more than a decade.

A lot of the downward pressure on the stock appeared to come from investors taking profits and moving into options ahead of the decision, according to William Lefkowitz, options strategist at vFinance.

"It looks like investors are taking profit, but then rolling some of that profit into 'call' options," said Mr. Lefkowitz. "They still get to participate if the news is really good next week, but they get to limit their losses to what they put into the options."

Call options grant the right to buy stock at a set price by a designated date. When an investor buys a call option, the risk is limited to the cost of that option. Even if the shares fall sharply, the trader's maximum loss remains the price paid for the option.

Arena shares dropped $1.80, or 15%, to $9.88 Friday after the shares had more than quintupled in value leading up to the decision. Just three months ago, the shares traded at $2.

Activity in call options was strong across the board, with options expiring in July busy at the $10 through $15 strike prices. Meanwhile, weekly options expiring next Friday were also active, with $12 and $15 call options seeing the most action.

Yet not all option buyers were as optimistic ahead of the advisory-panel decision.

One trader bought more than 9,300 July $8 put options, which grant the right to sell shares at that price, for $1.61 a piece. That means the stock must drop at least 36% over the next four weeks for the bet to break even.

Arena has been unprofitable every quarter since March 2001, according to FactSet data.

Options activity in the San Diego pharmaceutical company soared to more than four times the daily average Friday. The high price of option contracts suggests traders are pricing in a nearly 50% swing one way or the other in the wake of the FDA decision.

*** 2 days after the FDA approval ***
all gains (400%) happened in the few months leading to the decision