Industry Overview:
The Biotech industry plays a crucial role in addressing global challenges, such as healthcare, agriculture, and more. It combines biology, chemistry, and engineering to develop new drugs, therapies, diagnostics, and genetically modified organisms.
To make sure we are on the same page I’d first like to define my definition of what constitutes a ‘Biotech stock’ for our purposes today.
Biotech stocks are usually a small to mid cap sized company, that specialize in developing new drugs, medical devices, diagnostic tests, and therapies to treat various diseases. These companies are often either pre-revenue or barely making any money, with the majority of the enterprise value (EV) from to the treatment pipeline and it’s expected returns. Biotech companies also spend large amounts of money in Research and Development (R&D) which makes sense as a new treatment isn’t going to just fall into the companies lap. Now let’s take a look at how biotech companies develop new drugs.
Understanding the Drug Development Process
Before a new treatment becomes available, a biotech company must demonstrate its safety and potential effectiveness. Here's the typical journey:
Pre-Clinical Research: Initial testing in a laboratory and on animals assesses the drug's basic safety and potential benefits.
Clinical Trials (Human Testing):
Phase 1: A small group of healthy volunteers helps evaluate the drug's safety and dosage. (1-2 years, 60-70% chance of moving to the next stage).
Phase 2: A slightly larger group of patients tests if the drug shows signs of working as intended, along with further safety checks. (2-3 years, 30-40% chance of moving forward)
Phase 3: A much larger group of patients confirms the drug's effectiveness and monitors for side effects. (2-3 years, 60-70% chance of approval if it reaches this point)
Approval Application: If the drug successfully completes the trials, the company submits all of its data to the FDA for review. This final stage typically takes a year and has a high success rate (80-90%). Figure 1 shows just how long it can take to get a new drug to market.
Finally the long and costly development process in biotechnology makes biotech stocks inherently risky, but successful breakthroughs can lead to explosive returns.
These “explosive returns” are often due to a positive data readout. For example recently VKTX 0.00%↑ had a rather positive Phase 2 data print that led to an increase of 126% in the share price. I will expand on a few trading strategies that can take advantage of such moves later on in this article.
Tools and Resources:
There is a few myths I’d like to dispel when it comes to the biotech industry. First is the need for institutional grade data. Second is that you need work in the medical profession or have a medical background to have a sizeable edge in the biotech space. While both of these certainly help especially when it comes to the long term valuations and viability of a certain treatment. For trading catalysts valuations are not all that important.
Luckily retail traders have been gaining more access to tools that give traders a great deal of information regarding biotech companies along with upcoming catalyst. The two websites that I can personally recommended are biopharmaIQ & biopharm catalyst. Both of these companies for all intensive purposes provide pretty similar functionality. I will be using data from biopharmaIQ for this article. I also recommend taking a look at the two papers I attached in this section.
Websites/Data:
Papers:
Substacks:
is a great Substack dedicated to all things biotech. If this article was interesting to you and you want to learn more check out his work!Miscellaneous:
Centers for Medicare & Medicaid Services Drug Spending
Biotech Valuation Idiosyncrasies and Best Practices
Trading Strategies:
Holding through the catalyst (also known as the hold & hope)
As I’m sure you can guess this strategy is rather self explanatory. Once you’ve identified a promising company with an upcoming catalyst you buy shares and wait. That being said it is the highest risk way to play a biotech catalyst. Why is that? Well as mentioned at the start of the article most of a biotech companies value is in the companies drug pipeline and if one of their drugs fails to meet its primary endpoints. It can be devastating for a companies share price. As an example of what can go wrong we will take a look at ALLK 0.00%↑. After not meeting the phase 2 data endpoints the stock plummeted -57%. (Figure 3) However, if you take a look at Figure 2 you’ll see the possible gains if a promising drug does meet its primary endpoints. This strategy is high risk with the possibility for extreme gains.
Above you can see an example of a drug pipeline you never want to see for a biotech company that you own shares of.
Buying and selling before catalyst
Again this strategy is pretty self explanatory and fairly similar to the hold & hope strategy with one major difference. This difference of course is you heavily de-risk or totally de-risk by selling your position before the catalyst happens. For an example of this strategy in action we will review the successful data readout from CLRB 0.00%↑. Below in Figure 4 you can see how this strategy could play out. Overall this is a much safer way to trade biotech catalysts but it comes with it’s own problems. The main problem is Phase 1-3 data readouts often do not have an official catalyst date unlike PDUFA or FDA reviews. A simple way around this problem is taking profits as you go.
Shorting volatility via options
The final strategy has been adapted from a very similar strategy created by
, if you’re not subscribed to him I highly recommend doing so. I have also linked to his original article below please give it a read! Before going into any more detail for this strategy I have to add this disclaimer. This should only be attempted by those with a solid understanding of options, particularly selling options. So how does this strategy work? First, implied volatility for biotech companies is already higher than a similarly sized (by market capitalization) companies in other sectors. This makes sense as biotech companies are inherently more volatile due to the reasons mentioned throughout this article. So this strategy aims to profit from said volatility by selling out of the money options (OTM). For example let’s take a look at CRSP 0.00%↑’s successful PDUFA. Figure 5 shows a possible trade notice the entry date of 12/7/23 which was the day before the highly anticipated PDUFA date. Also notice the P/L date of 12/8/23 along with the P/L open column. (Figure 5) Even as CRSP 0.00%↑ had a historic treatment approval the shorting of these OTM options still profits handsomely due to the huge drop in implied volatility. Again I must stress this strategy is not for those who don’t have a strong grasp on options. If you’re interested by this strategy I highly recommend reading the article I have linked below.That is all I have for now. Thank you all for reading and supporting my work. I hope your week is going well and as always if you have any questions or comments please feel free to leave a comment below. (Or now with Substacks new feature feel free to DM as well!)
DISCLAIMER: We are not Financial Advisors, and all information presented is for educational purposes ONLY. Financial markets can be highly volatile, so good risk management is a must.