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Short selling volatile biotech stocks is a dangerous, albeit potentially rewarding, endeavor. Developmental stage biotech companies are infamous for surprising the market with mergers, joint ventures, favorable financing deals, and unexpected trial results that seemingly come out of left field, causing their stock prices to soar on a moment's notice. A perfect example of such a dramatic move in the biotech sector is Sarepta Therapeutics (NASDAQ:SRPT). Shares of SRPT shot up over 200% in one day on unexpectedly positive trial results for its Duchene muscular dystrophy treatment, eteplirsen. Even so, the volatility inherent in the sector attracts short sellers in droves, with the sector's short interest versus float ratio second only behind telecommunications.

The popularity of developmental stage biotechs amongst short sellers is easy enough to understand from a historical perspective. The sector tends to attract a large number of retail investors seeking out the next Amgen (NASDAQ:AMGN) or Abbott Laboratories (NYSE:ABT). However, investors would be wise to learn the history of early stage biotechs-turned-behemoths before buying the hype surrounding any particular drug, no matter what the potential valuation.

A Look Back At Amgen

A buy and never-ever sell strategy would have landed early Amgen investors an epic 81,000% gain. Sounds impressive, right? A historical view of the company and its stock performance tells a much rougher path for investors, however. Specifically, Amgen's future blockbuster Epogen received FDA approval on June 1st, 1989, and was expected to be a blockbuster from the get-go. Even so, the approval did little to appreciate the company's share price due to rampant litigation over the drug, even in the face of stellar sales numbers. In fact, Epogen would go on to average $1.7 billion per year in sales over 23 years on the market. Amgen's stock price nevertheless languished until the company received its second FDA approval on Neupogen in 1991. After an initial pop from the launch of its next blockbuster, however, the stock sank over the next three years. Specifically, if you bought AMGN the month following Neupogen's FDA approval on hopes of a parabolic return, you would actually be underwater on this investment three years to the date.

To make a long story short, Amgen's stock did not truly begin to appreciate the way investors expected until sales of its two flagship drugs had already fulfilled their potential as blockbusters (proven commodity), and the company built an impressive portfolio of other approved therapies. This process took nine long years to unfold, and many investors simply gave up long before Amgen became one of the world's largest Pharma companies. The primary reason this process took so long is because Amgen was getting sued every time it turned around, which is a risk integral to the biotech industry. Moreover, the company had to spend tremendous amounts of capital on developing or acquiring new drugs for its portfolio, causing the stock price to perform poorly for long periods of time. Amgen's story holds an important lesson that new biotech investors should take to heart. Specifically, one or even two blockbuster drugs does not guarantee mind-blowing profits for investors in the short term, and the months following an approval are the prime real estate of short sellers.

With this lesson in mind, I think it's fruitful to consider the short case for three of the most actively traded biotech stocks that received FDA approval this year.

1. Arena Pharmaceuticals (NASDAQ:ARNA): Arena received FDA approval for the first new anti-obesity drug, Belviq, in 13 years last July. Shares of ARNA have run from a low of $1.27 to a high of $13.50 this year as a result. Since this approval and no negative news to speak of, however, the stock has declined more than 40% from its post-approval highs at various points this year. The stock has been oscillating between $7 and $10 since approval. Even so, short interest has not declined substantially since approval, and the epic short-squeeze proffered by many never materialized. While the stock has bounced back the last few trading sessions, the company needs to give clearer guidance on DEA scheduling for Belviq scheduling in the near future, otherwise the stock could easily retest its post-approval lows due to increasing investor fatigue (i.e., investors that expected huge gains in short order moving on to other stocks).

Overall, I believe ARNA is an excellent short candidate at or above $9.20. A wide number of analysts believe that ARNA will underwhelm after the launch of Belviq, and I share their sentiment. Retail investors are expecting astronomical numbers from Belviq next year, and the chances of that happening are small. I will be so bold as to predict the stock re-tests $5 before the end of 2013 based on historical precedent in the biotech sector alone (see arguments above). Remember ARNA bulls, Epogen averaged more per year than Belviq is ever expected to, and this blockbuster did not propel Amgen to multi-bagger status a year after its launch.

The major risk of shorting ARNA is a buyout, which would be at a premium to today's share price. While totally illogical things happen every day in the biotech space, a buyout shouldn't be a real possibility until the first quarter sales numbers are announced. At that point, I would reassess if shorting is the appropriate way to play ARNA.

2. Amarin Corporation plc (NASDAQ:AMRN): Amarin Corp. received FDA approval for its fish oil pill Vascepa last July as well, which is a treatment for high triglycerides. The stock nearly tripled from $5.99 to $15.96 based on the approval. Moreover, rumors began to swirl immediately following approval about a possible buy-out by either AstraZeneca (NYSE:AZN) or Teva (NYSE:TEVA). Nonetheless, a buyout hasn't materialized, and Amarin is having a difficult time getting the FDA to issue New Chemical Entity (NCE) status for Vascepa. Although the stock has already declined an impressive 32% from its post-approval highs, short interest has only continued to climb (now at 14% of the float). Shorts are expecting that Amarin will have to issue another round of dilutive financing to meet the financial burdens of a solo launch for Vascepa. As such, AMRN could fall much further before year's end as dilution and investor fatigue set in. Without a marketing partner to share the financial burden and expertise to properly launch Vascepa, AMRN is setting up to be an excellent short candidate. Upon announcing a solo launch, AMRN could see $6 range in short order. The main risk of shorting AMRN is that a buyer gets antsy and jumps in before the NCE fog clears. The chances of this event happening are low, but this is a serious risk of shorting at these levels.

3. Horizon Pharma (NASDAQ:HZNP): Horizon received FDA approval for its flagship drug candidate, Rayos (Prednisone), on July 26, 2012. Rayos is slated to be prescribed for a wide range of conditions, including rheumatoid arthritis, polymyalgia rheumatica, psoriatic arthritis, ankylosing spondylitis, asthma, and chronic obstructive pulmonary disease. At least one author has thus predicted a whopping $1 billion a year market value of Rayos, and JMP Securities rated the stock a strong buy. The stock is now down 72% from its post-approval highs, and short interest remains high at approximately 9% of the float. With that said, short interest is starting to pull back from its summer highs, probably because the stock has found a strong level of support in the low $2s, where it was trading prior to FDA approval. I believe this stock has seen its best days as a shorting candidate, and is now a strong buy.

Conclusion: Developmental biotech companies are a great way to make money on the run-up to FDA approval, but become strong short candidates after FDA approval because of the difficulties associated with launching a drug. Amgen's story with its blockbuster Epogen sheds significant hindsight on the substantial problems these companies face, no matter how well the drugs perform in the marketplace. Armed with these insights, I believe two out of three biotechs discussed here are strong short candidates at current PPS levels (ARNA and AMRN). In both cases, the only credible risk with taking a short position is a buyout. With that said, credible news of a buyout should be easy enough to sniff out, giving you time to cover the position before the stock runs up too much. The third candidate, Horizon Pharma, has already been shorted to a strong level of support, and is now a buy, in my opinion.

Source: Hot Biotechs And Possible Shorting Opportunities