Let’s start with a simple definition of the “Run-Up Method”  Simply put, it is the following:

“Buying a stock months before a catalyst date and selling before the catalyst date.”

This currently is my preferred method of trading biotech stocks.  It takes a little more patience, but as a wise trader once said “Patience Pays” (thanks Trants).  In the world of stocks, most investors would hardly consider holding a position for only 3-5 months ‘long’.  But as most traders know, this may seem like an eternity.

Holding through an FDA decision is a VERY risky maneuver.  On rejection (or a CRL “Complete Response Letter”) the stock will certainly plummet, and any gains and initial investment will be lost.  On the other hand, if the FDA approves the drug the stock price will rise. However often this causes a sell-off as traders quickly take their profits.  Within a day or so the stock price will often close well below the peaks of the anticipatory run-up.

Analyzing these I have found that the most profit can be gained by selling the stock before the actual catalyst.  What determines when to sell?  That is the tricky part, as these stocks are often erratic.  It is important to set target goals and not get greedy.

Examples

Here are some recent examples of run-up plays and their prices leading up to their catalyst date:

POZN- FDA date for PDUFA (Trexime)
PPS 4 months out- $5.93
PPS 3 months out- $5.88
PPS 2 months out- $6.14
PPS 1 month out-  $9.55
Run-up peak: $11.66

SPPI- FDA date for PDUFA (Zevalin)
PPS 4 months out- $1.43
PPS 3 months out- $1.78
PPS 2 months out- $2.50
PPS Sell Date- $6.68

SVNT- FDA date for PDUFA (Krystexxa)
PPS 4 months out- $4.94
PPS 3 months out- $5.28
PPS 2 months out- $6.78
PPS Sell Date- $15.63

These are just 3 examples that show the potential profits of the run-up method.  See other recent stock and do your research.  Take a look at these: CTIC, NEPH, BDSI, SOMX, ISTA, DDSS, etc.

Personal Notes
1.) Do your best to not get greedy. No matter what the hype, sell all your shares before the FDA date. In most of the cases the vast majority of money is made in the run-up, not the approval. Lately stocks have even dropped after FDA approval.

2.) When selecting a stock to buy 4 months away from FDA approval there are multiple factors to consider, and every stock is unique. The smaller the company (the lower the share price) the more likely it is that the stock price will double, triple, or more.

3.) Maximum return on investment is with stocks with a beginning share price of under $10. In fact the lower the better, under $1 is a great start.

4.) Examine the type of catalyst.  Best returns are usually found on stocks with PDUFA (Prescription Drug User Fee Act) FDA dates. However other profitable catalysts include FDA medical device approval (510k), FDA Panel Reviews, Clinical Trial Results, and Medical Conference Presentations.

Other Methods

Besides the “Run-Up” method (“Buying a stock months before a catalyst date and selling before the catalyst date.”) there are a few other trading methods that can be used to get the most gain from BioTech trades.

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Free Shares Method

I learned the “Free Shares” method from the wise investor/ trader “Trants” on the MyStockBuddy.com forum. I will attempt to define it as:

“Buying a stock months before a catalyst date and selectively selling enough shares only to recuperate your initial investment, keeping the remaining stock for the longterm.”

It sounds much more complicated than it actually is. Take for example you purchase 1000 shares of company XYZ for $5 a share ($5000). In 3 months the stock price is now $10 a share. Sell 500 shares of XYZ to recoup your initial $5000 investment (500 shares x $10). Hold the remaining 500 shares for the long term.

As with all strategies this one has its positives and negatives.

Pros:

• Allows the option to catch major spikes on FDA approvals
• Allows long term investing
• Protects initial investment

Cons:

• Remaining shares may lose much of their value on FDA delays or CRL
• Is any money really ever “Free”?
• Requires trader to hold shares long term (not my style)
• Many stocks will drop value after an FDA approval due to trader sell off, decreasing the value of your held shares
• Ties up potential funds that could be invested into the next run-up play.

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Short Selling

Short selling stocks can be a very risky, but very rewarding way of investing. Below is the definition of Short Selling from wikipedia:

“In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than the seller received on selling them. Conversely, the short seller will incur a loss if the price of the assets rises. Other costs of shorting may include a fee for borrowing the assets and payment of any dividends paid on the borrowed assets. Shorting and going short also refer to entering into any derivative or other contract under which the investor profits from a fall in the value of an asset.”

That sounds complicated, but here is the BioRunUp version:

“You make money when the stock loses value.”

Why Short a Stock?

As a trader it obvious that we want to make money. That is the point of trading. However when you look at Biotechs, as with most other stocks, they have their ups and downs. Why limit yourself to only making money when the stock is on its way up? Played right, you now can increase profits riding the stock both up and down.

Isn’t Shorting “Evil”?

Many on various bulletin boards such as Google or Yahoo Finance love to blame “shorters” for taking down the value of a stock unfairly. Is it really unfair though? At times major players in the market may make these types of moves, and that is unfair, but for the other 99% of traders out there these are tools we should all reserve for special occasions.

When to Short?

Why do we open long term positions? Its because we feel that in due time, the price will rise. We feel that the stock is undervalued. Shorting is the opposite, we short when we feel a stock is overvalued. Its as simple as that.

What Could Make a Biotech Overvalued?

Biotechs can be a strange beast. They can explode up for seemingly no reason at all, or they can fall unexpectedly. However some factors can contribute to a Biotech being overvalued. These include:

• Buyout Rumors (They usually turn out to be false)
• Recent Patents (The market tends to over react)
• FDA Approval (Price may initially spike, but in most cases declines quickly)
• Clinical Trial Results (An actual money making product is still years away)

Examples

Take a look at two shorts that were very profitable.

ABIO

Take a look at the chart for ABIO

On Friday March 26th ABIO announced that it had received a US patent. The stock went wild and jumped from $3 to over $9. The Yahoo finance boards were full of people claming this stock was going to run to $100 a share. Viewing the patent, the companies financial statements, and upcoming events, it was clear to me that this stock was not worth $9 a share. I was able to short 2K shares @ $8.67. I covered my short at around $5 a share for a profit of over $7K.

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AEN

Take a look at the chart for AEN

AEN had begun a steady climb when on Tuesday March 30th rumors started that Pfizer (PFE (17.01 ↑0.06%) 17.01 ↑0.06%) was looking to buy them out. This rumor only spread more once AEN scheduled a conference call. Researching their product it seemed clear to me that these were just rumors. I shorted 2K shares @ $2.47. I covered around $1.50 for a profit of almost $2K.

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Obviously you can see that short selling is an excellent tool that a well rounded Biotech trader can add to their toolbox. In summary:

Pros

• Its easier to predict when a stock will fall than it is to predict when one will rise. Simply scan the market for hot stocks and research them.
• More opportunity for quick day trading profits
• Fear and panic cause more selling than buying

Cons

• Not all stocks can be shorted
• It can be difficult to find available shares to short during a price spike
• You must have a margin account with your broker
• You can lose much more money that you can gain if your trade goes bad.

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Options

Options are an area of Biotech trading that I have not spent much time in, but it can be a very beneficial tool in trading. Wikipedia defines options trading as:

In finance, an option is a contract between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or to sell a specified asset (underlying) on or before the option’s expiration time, at an agreed price, the strike price.

In return for granting the option, the seller collects a payment (the premium) from the buyer. Granting the option is also refered to as “selling” or “writing” the option.

• A call option gives the buyer of the option the right but not the obligation to buy the underlying at the strike price.
• A put option gives the buyer of the option the right but not the obligation to sell the underlying at the strike price.

If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price.^[1][2] The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a futures contract.

Hopefully you can see how using options can benefit the Biotech trader. Lets use the stock POZN as an example. POZN has an FDA PDUFA date of April 30th. That is 10 days away. Obviously it can be risky to buy shares of POZN right at this time. How can we minimize our risk and play both sides- make money on approval or denial?

Options can be the answer. First it would be good to guesstimate what we feel the price would be with an FDA approval. Based on calculations and research, I am going to say $17. What about on rejection (or CRL)? I would imagine$6.

If you feel POZN will receive approval from the FDA you can purchase a May 21st “call option”. Each call option consists of 100 shares, so one option would be the right to purchase 100 shares. POZN with a strike price of $12.50 will cost $0.85. As it’s 100 shares, the cost will be $85. You will pay the $85 and you will not be getting it back, no matter what, it is gone. So the FDA date rolls around for POZN, and guess what?! It got approved! What does this mean for you? If on May 21st the price is great than the strike price of $12.50 you can cash it in. You can either purchase the shares at $12.50 and resale, or you can sale the options that you own at a higher price.

How much money did you just make? So, here is a little more math:

The share price jumped to $17. If we sold them right away to make a profit of $4.50/share or in this case $4.50 x 100 = $450. Minus the $85 we paid upfront would give us a profit of $365. Our $85 risk just netted us a profit of $365, or 329%!

If we had just used that $85 to buy POZN shares instead of options and then we could buy say 8 shares at say $10.25 = $82. If the pps reached $17 then that would be $136 and a profit of 136-82 = $54 or 65%.

We make a profit of 65% but if we had bought the call options we would’ve made over 329%!

What happens if POZN gets a CRL and the stock drops to $5? Nothing. We are only out the $85 for the options. Thats it. Much less risk.

The same math can be applied in reverse if we believe that a stock is going to receive a CRL. At this point we would want to buy “Puts” instead of calls. Remember puts give you the right to sell the underlying at the strike price. If you bought $7.50 puts and on May 21 the price is $5, you have made $2.50 per share (minus the cost of the puts).

So with a relatively small investment you can try to play both sides of a biotech stock, both the calls and puts. For the above example, I would do the following:

Scenerio:
50 May Calls of POZN @ $12.50 = $4250 (5000 x .85)
50 May Puts of POZN @ $7.50 = $3250 (5000 x .65)

Best Case
POZN @ $17.00 = $18,250 profit
POZN @ $5.50 = $6,750 profit

Worst Case
If the PPS for POZN falls in between $7.50 and $12.50 I just lost all $7500 invested. Ouch, That hurts.

Summary

As you can see options can be another effective tool in trading biotechs, just be careful and do your research, but if you get good at calling the spreads, there is much profit to be made. And remember, traders rarely keep options until they have to be exercised, they can be traded any time before their strike date.