Know Your Options When Investing in Biotech Stocks

by: Zacks Investment Research

Investing in biotechnology stocks is certainly not for the timid or weak at heart. Stocks in the industry trade with perhaps the highest volatility in the market and move based on binary events. The ultimate of binary events for a biotech stock is the release of important phase III data or a decision by the FDA. Knowing that after you purchase a biotech stock you may either be very right or very wrong at some point thereafter, perhaps no sector lends itself to the usefulness of options better than biotech.

We have 2 strategies that may be helpful to clients. The first is on stocks we rate Hold but have big binary events coming in the next few months. We know these stocks are going to either move up significantly or down significantly after the news comes out, but visibility is low and we do not feel comfortable recommending investors Buy or Sell ahead of the news. In this case, the options straddle strategy makes perfect sense. Investors can purchase both out-of-the-money Calls and Puts at relatively inexpensive prices, knowing that after the binary event one of these investments is going to be worth zero and the other is going to be worth, hopefully, a lot more than you invested to begin with.

For example, Hold-rated Arena Pharmaceuticals (NASDAQ:ARNA) is expecting important Phase III data on obesity candidate lorcaserin at the end of March 2009. Data from this, the first of 3 ongoing Phase III trials, is expected to move the stock significantly.

Arena is currently trading at $4.21 per share. Investors can buy the April 2009 Calls with a strike price of $7.50 for only $0.70, and then also buy the April 2009 Puts with a strike price of $2.50 for only $0.80. Both options have significant open interest (a measure of liquidity), and for only $1.50 total per contract (100 shares), investors can be assured that if the phase III trial data expected in late March moves the stock roughly $3 in either direction, the net result should be a nice profit.

Another example for a similar strategy can be executed with Hold-rated CV Therapeutics (CVTX). Since the 2nd quarter of 2007, CVT has been bouncing between $8 and $10 per share; with virtually no volatility, it is an options trader's nightmare. But in January 2009, CVT received an unsolicited bid from Japanese big pharma company, Astellas, for $16 per share. The stock rocketed to $16 on the news and has been holding steady ever since. CVT’s board rejected the bid as inadequate on February 23rd.

One of two things is going to happen in the next month or two -- either Astellas is going to raise the bid to around $20 per share, or they are going to walk away and leave CVT independent. If Astellas walks away, we expect CVT to fall back down to that $10 support level. Investors can purchase the April 2009 Calls with a strike price of $17.50 for only $0.50 per contract. Couple this with the April 2009 Puts at $12.50 for only $0.45 per contract, and investors now have a straddle that is designed to pay off on either scenario.

The second strategy involves protecting yourself from a big disappointment on stocks where you are long the actual underlying security. For example, we have recommended for the past several months that investors purchase shares of Osiris Therapeutics (NASDAQ:OSIR). We are big fans of Phase III Prochymal, a stem cell product under development for graft-vs-host disease (GvHD) and Crohn’s disease. Osiris is currently trading at $18 per share. We have a $28 target.

Osiris is expecting to release pivotal phase III data from the GvHD program around the middle of the year. We are in the camp that believes the results will be positive, hence we think investors should Buy the stock. However, to protect (on the chance) if we are wrong, investors can look to purchase the August 2009 Puts with a strike price of $10 for only $1.25 per contract. If the data is positive, that $1.25 per contract you spent will pale in comparison to the profits you will make when the stock soars. However, if the data fails, at least you can re-coup some of the losses from the underlying investment with in-the-money Puts.

Another example of where we are bullish on the underlying stock but feel investors can use some downside protections is with AMAG Pharmaceuticals (NASDAQ:AMAG). The stock is currently $28 per share. AMAG’s leading product candidate, ferumoxytol, an iron oxide nanoparticle for the treatment of anemia in chronic kidney disease (CKD) patients, is currently under FDA review. In December 2008, the FDA issued a complete response letter on ferumoxytol, the 2nd in only a few months, relating to manufacturing and labeling issues.

We expect that management will work through these issues with the FDA in a timely manner, and that the FDA will finally approve the drug sometime around the middle of 2009. We rate the shares a Buy with a $55 target. However, if we are wrong and there are deeper issues with the pending application for ferumoxytol, AMAG’s stock could be in for a steep slide this summer. Investors can purchase some protection by picking up the August 2009 Puts with a strike price of $20 for only $2.10 per contract. If the stock is heading to $55, investors can certainly afford $2.10 for the protection. If the stock gets hit over the summer on yet another FDA delay, or an outright rejection, the Puts should pay off.

Options can be a very useful strategy for investing in biotechnology stocks.