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Biotech investors love to invest ahead of FDA approval decisions and Advisory Committee meetings because the stocks in companies facing these events often (but not always) run-up in price as the decision date approaches. This trading approach is full of volatility as sentiment waxes and wanes, news comes out both positive and negative, bear raids happen and because these events can have dramatic effects on the intrinsic value of the firms involved. One way to play run-ups while mitigating some of the downside of unfavorable decisions is to look for companies developing drugs in the same therapeutic area, but which are not subject to an FDA decision themselves. These derivative plays can lead to decent gains, often with less volatility than the companies facing binary events themselves.

Background

This past summer, the obesity drug approvals of Arena Pharmaceutical (NASDAQ:ARNA) and Vivus Pharmaceuticals (NASDAQ:VVUS) along with the approval of Amarin Corporation's (NASDAQ:AMRN) triglyceride drug all had derivative trades.

Below is a chart of price action of both ARNA and Orexigen Therapeutics (NASDAQ:OREX) for the last 3 months.

ARNA Chart
(Click to enlarge)

ARNA data by YCharts

When Arena received FDA approval for Belviq on June 27, shares of OREX jumped more than 25%. The rally in OREX continued until July 16, the day before VVUS' drug Qsymia was approved. Since then shares have been declining as investors realize that OREX still has at least 18 months to go before Contrave is up for FDA approval. Of particular interest, note that, when ARNA experienced a bear raid on June 21, shares of OREX were unaffected; yet, the peak return for OREX within the time frame of the chart matches that of ARNA.

Here is a comparison of Neptune Technologies (NASDAQ:NEPT) and Amarin Corporation before and after AMRN's approval for Vascepa.

AMRN Chart
(Click to enlarge)

AMRN data by YCharts

Note, in this case, NEPT is not a direct analog to AMRN. NEPT's Neptune Krill Oil has different uses than Amarin's Vascepa, but the stock still benefited from AMRN's run-up.

Several points should be kept in mind when looking at derivative trades. First, for companies undergoing an advisory committee meeting, the stock is halted during the course of the meeting, but the related stocks are not halted. Reactions to the positive or negative tone of the advisory committee meeting will often be reflected in the price action of the derivative trade. Second, many brokers will increase margin requirements on securities facing FDA binary events. They do this to make sure their clients are not over-extended should a large negative move happen. The derivative stock often does not face the same increased margin requirement. Finally, as the graph for ARNA and OREX above shows, once momentum players move on to another trade, the derivative stock will generally lose its upward momentum as well. It is important to trade accordingly.

Upcoming FDA binary events with derivative plays

Ironwood Pharmaceuticals (NASDAQ:IRWD) has a fast-approaching FDA approval date for their lead drug candidate linaclotide. The drug is up for approval to treat chronic constipation and Irritable Bowel Syndrome with constipation (IBS-C). The drug is a first-in-class guanylate cyclase type-C (GC-C) agonist that interacts with receptors on the cell-lining of the intestine to induce the cells to discharge more fluid, thereby encouraging intestinal motility. The drug is also thought to help block pain receptors thereby reducing the abdominal pain caused by the diseases it treats.

IRWD's drug is considered highly effective. In fact, one of the adverse effects of the drug is diarrhea which occurred in some 20% of patients and caused 6% of patients to drop out of the trials. (In clinical use perhaps lessening the dosage may mitigate this undesirable side effect.) This Seeking Alpha article from May provides an overview on IRWD and includes a summary of the market, efficacy and side effects of linaclotide.

IRWD stock recently closed at $12.29 per share. The stock has been in a downturn since mid-June, but this past week the trend seems to be reversing and a pre-PDUFA run-up may be just beginning.

The derivative play on IRWD is Synergy Pharmaceuticals (NASDAQ:SGYP). Synergy's lead drug candidate is plecanatide. Like IRWD's drug, plecanatide is a GC-C agonist meant to treat the same conditions of chronic constipation and, eventually IBS-C. Synergy recently completed full enrollment in its Phase IIb/III clinical trial of plecanatide and top-line results are expected by year end. SGYP's recently closed at $4.79 per share. The chart below compares IRWD and SGYP.

IRWD Chart
(Click to enlarge)

IRWD data by YCharts

Note that the two stocks seem to track each other fairly well. Until recently, SGYP was underperforming IRWD, but this week when IRWD shares started their run, SGYP ran even more. This is mainly due to the fact that SGYP has a much lower number of outstanding shares than IRWD (65.8M shares vs. 107.2M shares).

SGYP is likely to benefit regardless of IRWD's FDA outcome. If IRWD's drug is rejected, IRWD's lead in getting to market is reduced. Indeed, when the FDA announced a 3-month PDUFA delay for linaclotide in April, SGYP shot up from around $4 to almost $7 per share.

On the other hand, if IRWD's drug candidate is approved, plecanatide benefits because the GC-C class of drugs is validated as a treatment option for CC and IBS-C.

Investors looking to make long-term investments in either company should consider factors beyond just the share count and the short term price movement. Notably, IRWD is a larger company with established partnerships for linaclotide in the U.S., EU and certain pacific rim countries. SGYP is smaller and is at least 18 months away from FDA approval for plecanatide. Before SGYP can apply for approval, it has to conduct a second Phase III trial.

The linaclotide efficacy vs. plecanatide tolerability debate amongst some IRWD and SGYP longs is reminiscent of the Belviq vs. Qsymia arguments between ARNA and VVUS fans; however, similar to the obesity trade, a strategy of owning both IRWD and SGYP may make sense. Both stocks are likely to do well in the days leading to the September 9th PDUFA date.

Source: Derivative Trades On FDA Approval Events