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Shares of Zalicus (ZLCS) are down more than 25% since my last article outlining the risks and rewards of playing the company's pending Phase II trial results for Z160. To recap, Z160 is a first in class, oral, state dependent, selective N-type calcium channel (Cav 2.2) blocker being tested in two Phase II trials, one for Lumbosacral Radiculopathy (LSR) and another for post-herpetic neuralgia (PHN).

A few days ago, Zalicus announced that they are "on track" to report topline results from the studies in the 4th Quarter, with rumors swirling that the results could be released as early as November 18th (see hyperlink for an excellent overview on this argument).

Zalicus' Phase II trial data has garnered significant attention within biotech circles of late because of its tremendous value proposition. Specifically, Z160 is estimated to see peak worldwide sales exceeding $1 billion if approved, which is monstrous compared to Zalicus' market cap of roughly $100 million.

As such, Zalicus has drawn a number of comparisons to Acadia Pharmaceuticals (NASDAQ:ACAD) prior to their release of topline data for pimavanserin. And most folks closely following the biotech sector know how that story turned out.

I personally think Keryx Biopharmaceuticals (NASDAQ:KERX) and its flagship drug Zenerex is a closer parallel. But both examples show how the fortunes of nearly dead biopharmas can change in an instant.

The pending Phase II trials for Z160 certainly have that power for Zalicus. But as I said before, a double failure probably means the end of Zalicus due to the company's poor financial condition. So this isn't a trade for the faint of heart.

So how big of an opportunity is Z160?

If Z160 reports positive results for both trials, there is no reason to believe a market cap of $600 million isn't achievable in short order. There are myriad examples of biopharmas racing to market caps exceeding $500 million based on strong Phase II results for a potential blockbuster drug. Moreover, such a move would translate into a share price of around $27. Think that's too high? Then check out what happened to Acadia, Keryx, and recently Geron (NASDAQ:GERN) after reporting positive clinical data for possible blockbusters. If anything, I believe this estimate is conservative.

Interestingly enough, most pundits are calling for a $12 price target (see hyperlink below). So if you apply a 50% discount to my estimate, you get $13.5, which isn't far off the average price target.

Regardless, I believe everyone agrees that strong Phase II results for both trials will send ZLCS shares into orbit in a hurry. How high is mostly just fun speculation because the company is still a long ways away from seeing Z160 revenues. But it's safe to say that shares of ZLCS would be trading significantly higher than current levels.

So why is ZLCS sinking ahead of its data release?

If you recall, Keryx fell more than 7% in the month ahead of its Zenerex data release, and Acadia was faltering close to 10% prior to its release for pimavanserin. While that may seem odd, there is a theme that runs throughout these three companies. The fate of all three companies depended on reporting positive trial results. If Zalicus fails in this regard, for instance, there is good reason to believe the company won't survive much longer. So in all three cases, there is/was significant risk heading into a make it or break it clinical catalyst. And the stocks traded accordingly.

Are there any tell-tell signs about the possibility of a pending failure?

The answer is yes, but not in a conventional manner.

I've read over every peer-reviewed article I can find covering N-type calcium channel blockers, and the impression I come away with is that the pending trial results are a toss-up. To date, the safety profile and bioavailability of Z160 looks promising, but there isn't anything definitive to point to that would assuage my worries.

So I've decided to let the shorts be my guide on the Zalicus trade. Following short sellers in the biotech sector is a great way of making out-sized gains. When they jump all over a biotech, that usually spells trouble for the company's share price, and its primary value driver.

Thus far, short sellers have mostly taken a pass on Zalicus ahead of its pending clinical catalysts. The last reported short ratio is a measly 0.66. What's key going forward is the updated short numbers that should be released next Monday. If the shorts have started to pile into ZLCS ahead of this catalyst, I am going to stay far away. I personally believe that information is commonly leaked in the biotech sector, and short sellers usually get their hands on it first. Why else would someone take out a huge Put Option bet ahead of the recent Amarin (NASDAQ:AMRN) Advisory Committee, and be spot on to boot? In regards to Zalicus, a short position would be extremely profitable and hard to pass up if Z160 is going to fail. You could probably naked short ZLCS without ever having to worry about covering--that's how important Z160 is to the future of the company.

By contrast, if shorts aren't being attracted to ZLCS in droves in light of the potentially massive gains, my guess is that they are expecting positive trial results. Interestingly enough, the short position in ZLCS dropped by nearly 80% last May when the company announced plans to proceed with the Phase II trials. While short interest has been creeping up ever since, it's still well off of its highs earlier in the year. So I am particularly interested to see what the new numbers tell us.

Bottom line: Keep a close eye on the short ratio for ZLCS. It could be a key indicator of things to come for Z160 specifically, and the company in general. And remember, this is a trade that is high risk/high reward. Don't invest money you simply can't afford to lose.

Source: Key Issues Surrounding The Zalicus Catalyst Trade