This past Wednesday shares of Human Genome Sciences (HGSI) exploded higher, nearly doubling in price. The stock jolt followed a surprise disclosure the biotech’s Benlysta drug partner, GlaxoSmithKline (GSK) had made a $13 per share buyout bid for the company. Quickly rejected by Human Genome’s board on the pretext the unsolicited offer failed to reflect value inherent in the company, the company authorized the exploration of strategic alternatives and retained Goldman and Credit Suisse to oversee the process.
Technically, the report sent HGSI gapping from just above $7 and near 52-week lows of $6.50 set back in December to north of $14 and about 8% above the premium and roughly $2.6B bid on Thursday but well-below 52-week highs of $30.15. With that in mind and despite the massive jump, shares still sit below both a 38% retracement near $15.50 and its 50% level at $18.35. Without knowing what would be acceptable to Human Genome’s board, one might wonder whether if one of those levels might prove harmonious enough to accept?
Figure 1: Human Genome (HGSI) Monthly
Option traders have taken the bid as a serious enough proposal and one likely to lead to a buyout based on a rather severe volatility crush reflecting a negative skew from near-term premiums in the high 30s to low 50s down into the mid-20s for longer-dated options like the Jan14 LEAPS. The variance compares to pre-report implieds priced fairly in the 60s – 70s and matching statistical underlying volatility seen across-the-board.
The skew with near-term premium trading, in implied terms, well above longer-dated options suggests traders favoring the purchase of closer-in calls and puts and a willingness to sell longer term options as a hedge. This new equilibrium is basically the collective order flow looking to sell volatility or Vega while maintaining long curve or Gamma, until participants no longer see the prices as attractive for such strategies.
A position which embodies these two characteristics is the short time or short calendar spread. As a long calendar wants a stock to settle at the positioned strike at expiration of the near-term option and / or implied volatility to lift, so the spread can widen; the short calendar wants the opposite of large movement and / or a volatility crush.
Figure 2: HGSI -10x Oct / Jan14 15 Call Calendar
Were shares of HGSI to get bought out at let’s say $18.35 and the 50% retracement level in October and where a good deal more shareholders would feel better about themselves; options still on the board would be priced for intrinsic value or hold no value whatsoever based on a cash deal being accepted.
Shown above and to illustrate one such position is a short 10x October / Jan14 15 calendar which buys 37% IV to sell 26% IV for $0.50. As mentioned, the largest risks would be a deal that remains on ice come October and shares having drifted higher into the 15 strike. At that point, the curve / gamma of the near-term contract will have failed to have provided any profit potential and the trader would remain short the long-term option in need of a similar and now more costly hedge or be required to exit for a loss.
Despite those risks and while on paper taking the other side of this position, i.e. buying the calendar and receiving the favorable skew of buying low, very low and selling relatively expensive premium, would seem the more logical and theoretically correct trade; traders should think twice before entering. In the end and as this is Wall Street; respecting the idea of that which is obvious, is obviously wrong most of the time, makes sense and likely cents even when things don't seem to add up. HGSI reports Wednesday before the open.
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.