This is a follow-up to my April 9th post about Dendreon (DNDN), a pharmaceutical maker, or rather would-be maker, in which I noted an extreme price spike in the stock due to possibly favorable news on its Provenge drug in development. I speculated that the stock would not hold price and pointed DNDN out as a bad covered call play, but a good short, puts being too expensive. DNDN had spiked to $21.78 at the time of my post and later reached a high slightly over $25.

Of course, a bear call spread was a potential trade, too, or a naked call. See how one trader actually handled DNDN.

A CallWriter member tried to short the stock but found none available to borrow from two different brokers. He also found, as I suggested, that the puts were too pricey, but nonetheless bought the OTM May 17.50P and closed it for a .30 profit, not bad. When the market sees an aberrational spike like this, options get really expensive. They remain expensive as volatility continues, since people are willing to pay a big premium for options.

His big score, though, was writing the ITM May 20 Call for $8.20 when the stock was $24.35 (not too far off the stock’s high). He exited the call when it fell to $2.60, a pretty good score of $5.60 a share! Note that the call’s low has been $2.00 since the stock’s high, so he got most of the possible profit. Naked calls normally are written at an OTM strike, above a strong resistance level or at least above the stock’s apparent high-water mark, yet this trader sold a deeply ITM call with $3.75 of time value in the next expiration month. The trader’s real risk obviously was a continued move up in the stock. But the trader won if 1) implied volatility collapsed, even if the stock remained at that price level or pulled back only slightly, 2) the stock price collapsed (as it did) or 3) when time value eventually evaporated close to expiration (which certainly would have happened as expiration approached and the ITM call’s price moved close to parity), in either of these events enabling him to close the short call at a profit. Significantly, he sold a May call, which gave him time and room to operate; June calls were not then available and the April call might not have allowed enough time for a pullback or change in volatility.

In other words, the high time value - which would have been poisonous for someone buying the calls - worked in favor of someone writing the calls. Remember, buy low volatility, sell high volatility, and this is an object lesson in how to do it.

Note that someone not approved to write naked calls could have done a very similar trade by also purchasing a higher-strike call, turning the naked call into a bear call spread. However, the high level of implied volatility would have made a bear call spread less profitable, due to the high cost of the long call, even at the 30 strike.

This ITM naked call was a smart, gutsy play - and the trading was pretty icy. Good work, Barry!

This entry was posted on Sunday, April 22nd, 2007 at 10:20 pm and is filed under Covered Calls, Trading Tips. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.