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Next week we kick off an extremely exciting October for biotech investors with the PDUFA date for Alexza’s (NASDAQ:ALXA) AZ-004 inhalable loxapine treatment for agitation associated with schizophrenia and bipolar disorder. Generally, I avoid PDUFA dates unless my due diligence is particularly up to snuff.

This is responsible investing; if you don’t know at least as much as the average investor on a particular stock, you’re really just gambling. However, I’ve abandoned the idea of 'never hold through a PDUFA date'.

This dogmatism, while useful to the lay biotech investor, simply doesn't hold up upon further analysis. Different investors have different tolerances for risk and each event has different risk/reward profiles. Truthfully, there’s a lot of money to be made in especially risky investments and riskier stocks tend to return more over time.

The fact that in general, riskier stocks return more, is actually one of the few truisms in stock market investing (this can be seen in the research of Fama and French relating to their adjustments to CAPM).

That being said, holding through a binary event does inject a lot of risk into your portfolio. Limiting that risk is the responsible thing to do. never ‘bet the farm’. That is, never allocate a majority portion of your portfolio to one stock in general, but especially one that is going through a binary event.

Know that nothing is ever a ‘sure thing’…ever. I have a portfolio that I would call rather risky and I would never allocate more than 20% of my portfolio to a stock going through a critical binary event – and this is probably still too high for most people.

So let’s get back to AZ-004. For those of you still holding onto your ALXA shares, you have a critical decision to make in the next few days: hold, sell, or put. You can hold every bit of your shares – risking whatever gain you’ve already amassed – and roll the dice hoping for a favorable decision and a hefty profit.

You can sell part or all of your position; playing it safe and realizing what is likely to be a modest gain. Lastly, you can try to manage some of the risk by purchasing protective puts. This strategy gives a balance of the two outcomes – modestly limiting your upside while providing a concrete limit to your losses. Rather than follow your gut on which strategy to pursue there’s a reasonably simple way to help you make your decision using Excel and speculating on just a few numbers.

First, let’s compare your potential profit or loss on a range of outcomes for the hold and put scenarios (selling 100% would obviously give you a straight line at 0). I’ve also included the ‘sell half’ scenario so you have a graphical representation of how that would do. I'm using Friday’s closing price of 3.15 and the 2.50 October put at $0.40/share.

(Click on all images below to enlarge)

The question we’d really like to figure out, however, is what we should do depending on the likelihood of approval. Now of course, not all prices are equally likely upon decision by the FDA. There's really only a handful of likely outcomes in this case. I'd like to zero in on what I'd call the two most likely: a reasonably positive approval and a really bad CRL.

I say a ‘really bad CRL’ because if there is a CRL I’m assuming it will put the entirety of Alexza’s Staccato franchise into question. Likewise, an approval would be very good as it would serve as proof-of-concept their drug delivery platform. In those two scenarios, I’ll assume a $6.00 price target on approval and a $1.50 price target on CRL.

Given those price targets, we can plot a weighted average of those outcomes against the ‘odds of approval’ to get the graph below. The calculation is relatively straightforward, it's just the odds of approval times approval target plus odds of CRL times CRL target. Notice, I’ve left off the ‘sell half’ scenario as all it does it limit upside and downside with similar x-intercepts.

Using the above graph, we can now determine the most prudent action depending on what we expect the odds of approval to be. If the odds of approval are greater than 60%, you should hold your shares and not buy protective puts.

This means that if you went through this event enough times, holding and not buying protective puts would net you the most profit. As this is a higher risk scenario (downside over 50% is still possible), you should be mitigating risk elsewhere in your portfolio – namely keeping the total value of the investment small compared to the value of your portfolio as a whole. You could also consider adding more shares in this case, again depending on how your current risk exposure compares to your optimal risk exposure.

If the odds of approval are between 30% and 60%, you should hold and buy protective puts. Again, this means if you ran this exact scenario enough times, put-buying would yield the most profitable strategy. If the odds of approval are less than 30%, you should sell your shares.

If you expect odds of approval to be this low you’re better off looking for other investment opportunities. The risk/reward just doesn’t make sense. You may also want to consider flipping your position to the short side to maximize potential profits.Do your own due diligence to come up with an ‘odds of approval’ estimate. Ultimately, there will always be a little subjectivity but try to keep emotion out of your calculation entirely. For what it’s worth, RBC Capital puts odds of approval at 65% and Gekkowire has estimated odds at 40%. Either way, it looks like selling out completely may not be the prudent thing to do, depending on your risk tolerance and what other investments are available to you.

Feel free to run your own numbers by downloading my spreadsheet here.

Disclosure: No positions.

Source: Alexza Pharmaceuticals: Hold, Sell, Or Put?