How to Manage Risk in Speculative Biotech Stocks

When most companies go public, they are somewhat mature. They typically have earnings and cash flow.

Tech company initial public offerings, or IPOs, are a bit different. The companies are often not yet profitable.

And biotech IPOs are a special animal altogether. Not only are the companies usually not profitable, but most of the time they don’t even have a product on the market yet.

For example, last Thursday, Surface Oncology (Nasdaq: SURF) had its IPO, raising more than $119 million. The company is developing antibodies that target tumors. It has one drug in Phase 1 trials – the earliest stage of human trials – and six drugs that have not yet entered clinical trials.

So investors buying Surface Oncology are essentially hoping that one day it will get a product approved and on the market, and that said product will sell well.

When things work for these small cap biotechs, it can be insanely lucrative.

Take Pharmacyclics, for example.

The company, focused on treating cancer, went public in 1995, offering 2.15 million shares at $12 per share and raising a little more than $25 million.

It wasn’t until 14 years later that Pharmacyclics conducted its first human trials of Ibrutinib, which went on to become the company’s first FDA-approved product in 2014 and a blockbuster drug.

The following year, AbbVie (NYSE: ABBV) acquired Pharmacyclics for $21 billion.

If you had bought Pharmacyclics on December 7, 2009, after the company presented positive results from a Phase 1 study, you could have bought the stock for $2.35. A little more than five years later, the company announced it was being acquired and you could have sold it for $230.48.

Of course, you would have had to hold on to a very speculative company for more than five years to do it. But even if you had sold pieces of the position off over the years and were left with a fraction of the original position, you would have done extremely well.

Pharmacyclics is the exception though, not the rule. Most early-stage biotech companies never have that kind of success. Many never get a drug on the market.

In fact, a drug entering human trials has about only a 1 in 10 chance of being approved. So it makes sense that the rewards need to be large to take on that kind of risk.

Since these stocks can be very speculative, there are a few things you can do to lower your risk.

1. Place a trailing stop. I recommend using a 25% trailing stop on most trading positions. That means you raise the stop as the stock moves higher. That can help limit your losses if things go wrong.
2. Position size accordingly. I recommend never putting more than 4% of your risk capital into any one position. That way, if you get stopped out for a 25% loss, you’ve lost only 1% of your total capital.
3. Keep an eye on catalysts. Small biotech stocks don’t often react to earnings reports like most stocks do. But they can fly around after the release of clinical trial data or a presentation at an important conference. Be aware of when data is coming out or when a company is scheduled to present at a conference so you can pay attention to how the stock responds to news. Companies will usually issue press releases mentioning the dates they’re presenting at conferences.

Specific dates for clinical data releases are usually not announced ahead of time. Rather, companies will give a rough time frame for the data release, such as “first quarter of the year.”

You can hit some big home runs in the biotech sector, but you need to manage your risk when trading these stocks.

If you handle your risk properly, you’ll be able to take more big swings and hit one of those portfolio-altering gains.

Good investing,

Marc