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How To Play Valeant Pharmaceuticals Tomorrow As The Company Is Technically In Default As Of Today

It is official now: Valeant Pharmaceuticals (VRX) is in technical default for failing to file an annual report in March. But before you freak out, let me specify something: only one investor, Centerbridge Partners, has called on its loans. The firm is a relatively small investor - it owns about $250M of Valeant's bonds (the company's total debt amounts to almost $31B). The news is very recent: in fact, the information came out after the market close tonight. The stock is down almost 4% after-hours (some investors are saying it is down 20%), according to Google Finance:

(Source: Google Finance)

I do not know where the stock will open in the morning but I am sure it will get ugly. The good thing about the default call is that it is not a default itself: the company will have 60 days before the due date when it must file the long-awaited 10-K report. If it fails to do that by mid-June, it will officially be in default. In the meantime, this news can potentially trigger a chain reaction among other creditors, sending the stock in a free fall in a matter of days. 

If you have the guts, turn your attention to options - they will become expensive as implied volatility is surely going to rocket all the way to the stratosphere. This will be the best time to sell the options. As you could guess, I would recommend selling June options as they expire approximately at the same time as the 10-K is due:

(Source: TD Waterhouse)

The straddle is currently worth about 40% of the current market price. It will become more expensive tomorrow, if the stock falls through, indeed. Notice that I have also highlighted the out-of-money options, which are approximately equidistant from the straddle. Why did I do that? Well, I do not have a crystal ball, so I want to hedge my downside (both if the stock goes to zero or shoots through the roof). This strategy is also called an iron condor

If you add up the premiums from the straddle and subtract the cost of the OTM options, the net credit position will be approximately $8.40 per share (about 26% of today's closing price). This is effectively your maximum return on the trade. The maximum return will be realized if and only if the stock expires at the $30 strike price. For your convenience, the whole risk-return matrix is given below:

(Source: optionsprofitcalculator.com)

Note that the prices are going to change tomorrow, and the entire matrix will look different. However, the idea remains unchanged.

What I really like about this trade is that I can make over $800 on one options contract (equivalent to 100 shares), while the maximum risk is just above $400 (that is, the loss is coming from my own pocket: I lose the premium plus I pay $400 out of my own account). To me, this risk-return ratio is very appealing. I am looking forward for the market's opening tomorrow to update my trade idea and come up with new numbers.

Stay tuned and good luck with your investing!