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How to Prep for the Inevitable Bursting of the Biotech Stock Bubble

NEW YORK (TheStreet) -- Joseph Kennedy Sr. is said to have gotten out of the markets before the Wall Street crash of 1929 because a shoeshine boy gave him stock tips.

I'm reminded of this story today because the biotech bull market that began at the start of 2012 has traders feeling extra cocky and forgetful about the inevitable fact that stocks do go down. I see young, inexperienced traders starting their own paid subscription services to trade penny stocks like Hemispherx Biopharma (HEB) and amateur investors publishing overly optimistic articles that can move biotech stocks like Acadia Pharmaceuticals (ACAD) or Cyclacel Pharmaceuticals (CYCC) 20%-plus in a single day. People are becoming concerned if their stock does not move 5% up per day, posting messages like, "What's wrong with stock XYZ, it's only up 1% today?"

Like Kennedy, seasoned traders view this euphoria and hubris with alarm. Too many biotech traders are relatively new to the market, which means they've only been trading during this most recent bull cycle. To these newbies I offer the following advice: Recognize that we are in the midst of a biotech investing bubble. This doesn't mean you need to "pull a Kennedy" and get out of the market completely, but you should be prepared to shift trading strategies to maintain maximum profitability and protect profits.

The good times in the biotech sector may continue so take advantage while it lasts. But if you want to be a trader with longevity, you'll consider taking the following precautionary steps to insure against getting caught flat-footed when the market downshifts.

This bubble may still have room to grow, so while it is here take advantage of it. Wise traders do the following to make sure they do not get caught up in the hype and end of giving back all their gains in the event of a market shift.

1. Do not overextend yourself in one position.

With biotech stocks making big moves, it's easy to allocate outsized and risky percentages of your portfolio into one position. This is dangerous in all sectors of the market, but especially in the world of small-cap biotechs where companies have so much riding on one product. These companies are usually low on cash, and ready to take advantage of the same inflated prices that you're looking at as a trader. If you're overextended, you don't want to be caught in a dilution, unexpected negative news, or an overall market correction.

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