Profiting In Biotech

Is biotech investing the same as investing in slots? Is there any way to consistently build wealth in this sector? Many investors avoid biotechnology altogether, appalled at the prospect of stocks that can nosedive over 60% within minutes, while others are attracted to the extraordinary gains possible for companies that receive Food and Drug Administration (FDA) approval. All investors wonder: Is biotech investing a hopeless gamble? Without knowing what the FDA will decide beforehand, is there a way to trade biotech stocks with a high probability of success?

BUY THE RUMOR
It may come as a surprise, but there are ways to make low-risk trades in the biotech sector. In this article, I will explore a trading method built around a predictable anomaly of stock performance that is unique to the biotech sector.

The anomaly is the application of the "buy the rumor, sell the stock" mentality to FDA decisions. Here is the secret: Shares of biotechnology stocks tend to rise in the weeks and months prior to major FDA decisions. Let's call it a "bio runup." This runup allows a trader to profit from the increase in shares of companies well before any major FDA decision date, simply due to the speculative rally in the stock prior to the decision. A bio runup trader tags along for this rally prior to the announcement, but selling before the FDA says a word. This is the "buy the rumor" concept in its purest form.

It's simple and theoretically sound, sure, but does the behavior of public markets actually support this strategy? I will examine all FDA decision date runups from last year and see if there might have been a way to build wealth using the bio runup method.

ANALYSIS
In 2010, there was a total of 59 runups that included either a FDA panel or PDUFA decision date (two of the major FDA decision dates). I analyzed all 59, primarily focusing on those companies worth less than $1 billion. Because adding data for companies worth more than $1 billion tipped the odds in my favor (including risk/reward ratios), I excluded them to err on the side of caution.

I gathered two months' worth of data (44 trading days, to exclude holiday interference) for each runup. For example, MannKind's (MNKD) drug Afrezza had an FDA panel decision date on December 29, 2010, so I collected prices starting on October 27, 2010. I then evaluated a variety of holding durations:

• Raw positions (buying two months prior to the FDA panel date and selling after the panel decision)
• Raw except five days prior (selling a raw position five trading days prior to the panel decision)
• Six weeks prior (buying six weeks prior and selling five trading days prior to the panel decision)
• Four weeks prior (buying four weeks prior and selling five trading days prior to the panel decision).

Each trading method was analyzed according to two metrics:

• Return% (percentage gain or loss on the trade)
• Risk average (square root of the spread between the return and the mean for the appropriate return average squared divided by the appropriate number of holding)

The results of the study of bio runups prior to FDA panel decisions can be seen in Figure 1.

FIGURE 1: RESULTS OF STUDY OF BIO RUNUPS PRIOR TO FDA PANEL DECISIONS. The "raw except five days prior" method (being long stock from two months to five days before the company's FDA panel date) produced the best results. On average, those using this style generated a return of 13.29%, with almost the best risk management of all methods (just 4.89% average risk).

I continued this analysis by simply substituting FDA panel decision dates with PDUFA dates, which are the other major decision date for the FDA. Using the same holding criteria and risk/return definitions produced the results you see in Figure 2.

FIGURE 2: RESULTS OF STUDY OF BIO RUNUPS PRIOR TO PDUFA DATES. The "raw except five days prior" method performed the best of all methods. Based on the results from this phase, investors benefitted most from a two-month position with an exit five days before the PDUFA date. This method yielded an average return of 21.32% with a very low average risk of 4.32%.

The "raw except five days prior" method performed the best of all methods. Based on the results from this phase, investors benefited most from a two-month position with an exit five days before the PDUFA date. This method yielded an average return of 21.32% with a very low average risk of 4.32%.

From the results, we can see that the four weeks prior method has been the least profit-maximizing method. Second, and just for fun, I decided to perform a linear regression analysis of seasonality on the bio runup trading method. Leaving the complicated mathematics aside -- they are available on the biorunup.com website for you diehard statisticians -- I discovered that, for whatever reason, winter provides a seasonal boost to the bio runup method of 6.78%, spring boosts by 5.72%, summer boosts by 7.15%, but autumn detracts from the method by 18.17%.

CONCLUSION
From the analysis described here, we know that a consistent anomaly exists in biotech stock market that has provided a legitimate trading opportunity with more than a 1:3 risk/reward ratio. A persistent anomaly exists in biotech stocks in the two months prior to major FDA decisions. Simply stated, biotech stocks tend to rally prior to FDA panel and FDA PDUFA dates.

In a real-world application, it seems as though the most profitable method for trading this anomaly is to take long positions in biotech stocks starting at two months prior to the company's major FDA decision date (either panel or PDUFA) and selling those shares five trading days prior to the decision date.