A friend of mine once told me that a good strategy is to buy a basket of random biotech stocks. The idea is that one or two will discover groundbreaking treatments and shares will rally exponentially, as the company goes from a research and development biotechnology company to a cash flow generating pharmaceutical machine. Consequently, while many biotechs might languish or even go bust, the gains from the winners will more than offset the losses from the losers. While I never tried it, watching some biotechs sometimes double or triple on FDA news and other developments makes me wonder. So, let's try a little experiment - buy out-of-the-money call options on biotechs that face important FDA decisions and other news.
To find potential candidates for the experiment, I did a screen for biotechnology names with high implied volatility (IV) or rich options. Expressed as a percentage, implied volatility is computed using an options pricing model. You might think of IV as gauge of how much a stock might move. A stock that is expected to move fast, like a biotech that faces an important FDA decision, generally has high IV. Slow stocks, like grocery store chains, utilities and major pharmaceutical names, tend to have low implied volatility.
Biodel (BIOD), for example, has extremely high implied volatility ahead of an October 30 PDUFA date for the biotech's Linjeta, an injectable treatment for diabetes. Good news could send the stock surging. Bad news might sink this biotech. Consequently, IV is reaching towards 400 percent ahead of Saturday's news.
Suffice it to say that BIOD options are very rich! Shares are trading at $3.50 and a November at-the-money 3.5 call is trading for $1.30. Therefore, if an investor buys the contract, they are paying $1.30 in time value for a contract that expires in three weeks. That's hefty premium and a sign that the options market is bracing for a big move. IV is very high.
How much can we expect a biotech to move if there is a favorable FDA decision? It's very difficult to know. Looking at the volatility skew between November options (395%) and December options (275%), one of our models hints at possible move of more than $4.00! Or, we can assume that good news in a biotech could lift shares back towards 52-week highs. In BIOD, the 52-week high is $6.25 and, if an investor pays $1.10 for a December 4 call, there is a good chance they will more than double their money on a positive decision from the FDA. That is, if the stock rallies back to its 52-week high of $6.25, the December 4 call will be worth AT LEAST $2.25 ($6.25 - $4.00 plus any time value), for a gain of 104.5%
Avanir Pharmaceuticals (AVNR) also faces news over the weekend. The FDA is reviewing its AVP-923, which is a treatment for a neurological disorder called pseudobulbar affect, and the PDUFA date is October 30. Shares trade at $3 and the 52-week high is $3.73. However, good news is likely to lift shares significantly above that level. Implied volatility in the November options is near 425%! Our model, which compares the IV of the November options to longer-dated options, hints at a possible move of up to $3.00 per share, or a double. If so, an AVNR December 3.5 call will offer a hefty payday (see table).
The FDA has accepted MannKind's (MKND) resubmission of an NDA for Afrezza, an inhaled insulin drug, and set a PDUFA action date of December 29, 2010. Consequently, implied volatility in MNKD January options is at 185%, compared to 105% in the December options. This "volatility skew" indicates that the market is priced for a big move between the December and January expirations, or around the time of the December 29 PDUFA for its insulin drug. If successful, could this stock find its way back to a 52-week high of $11.12 per share? MNKD January 7.5 call at $1.50 would be worth at least $3.60 if shares return to those levels, a gain of 140%.
Keryx Pharmaceuticals' (KERX - Get Report) New Drug Application (NDA) for Zerenex, a treatment of hyperphosphatemia, isn't scheduled until 2012, but study results are due before yearend. Consequently, implied volatility in the December options is elevated and approaching 200%. The stock has a 52-week high of $6.67, which it could easily top if the data are good. If so, December 5 calls at $0.80 could offer a double or more.
Oncothyreon (ONTY) is collaborating with Germany's Merck KgaA on a vaccine called Stimuvax. The treatment is designed to fight lung, breast, colon and prostate tumors. ONTY took it on the chin in March on news trials of Stimulax were halted due to safety concerns. The stock came under additional pressure in mid-September on reports the biotech was raising cash through a private placement. However, shares have stabilized around $3.30 since that time with help from Stimuvax safety and survival data released October 7. Implied volatility is elevated in November and December, as investors await word about the fate of the treatment. News that the trial is being resumed or other positive data could drive shares of this battered biotech substantially higher through mid-2011. A February 4 call option, at $0.40, would offer a hefty payoff if it does.
Buying calls on biotechs ahead of FDA news is very speculative activity and involves substantial risk. The idea is that big gains from the winners will offset the losers. It's really like playing the lottery. You are paying a relatively small premium for the potential for a big percentage gain. By buying calls in a basket of biotechs, rather than playing one individual name, you are spreading the risk and limiting the potential reward as well. You can also exercise the calls at expiration and then take ownership in shares of only those names that are making progress on getting drugs approved. Of course, if a large percentage of the names get good FDA news, the result is going to be hefty profits. On the other hand, if most or all fall victim to bad FDA decisions, the result is big percentage losses.
See you Monday!
At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.
Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.
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