The Next Great Biotech Short Squeeze

by: Andrew Vaino

I like to short as much as the next investor. Not only is there a palpable frisson in taking a strong position against what the majority of the market thinks (I have seen very few stocks where short interest was over 50% of the float) but, if played correctly, there can be lots of money to be made.

In connection with a side project, I came across a paper from UMass Amherest on how capital markets respond to successes and failures of biotech companies (J. Prod. Innov. Manag., 2004, 21, 297–308). Looking at abnormal returns after both positive and negative FDA rulings, the authors concluded that the magnitude of price decline on bad news was greater than for positive news. The best explanation for this is that as humans we react more strongly to negative events than to positive.

While I’m happy to make money on the short side, I also like to make money by taking advantage of large short positions that don’t work out for the bears—the short squeeze. Biotech stock prices are relatively uncoupled to broader market conditions, and strongly levered to science. That is, biotech stocks make major moves based on discrete rational events.

The past couple of weeks have provided a couple of exceptional examples of short squeezes in biotech stocks. On a positive recommendation of an FDA advisory panel, shares of Dendreon (NASDAQ:DNDN) went from $5.28 on March 28 to $12.93 on March 30. Short interest on DNDN was over 30% prior to this event. The short squeeze raged for another week, with the price peaking just over $25 seven days later.

Similarly, Avanir Pharmaceuticals (NASDAQ:AVNR) a company I was happy to short (quite successfully) last October announced on April 18 positive news from a phase 3 study on a treatment for diabetic neuropathic pain. Prior to the 18th, the stock was trading at $1.27 with short interest of 20%. After announcement Wednesday morning, the price kept going up all day, finally peaking Thursday morning at over $6.50.

So, buoyed by this I went looking for other possible short squeeze biotech plays. Using a stock screener I selected biotech stocks with short interest over 20%. From this list I looked at each stock to see if there was a significant clinical event expected in the near future. In many cases, for example a company releasing results of a phase 3 study, there may or may not be a predefined action date, as there would be for an FDA decision. To get a better handle on time frame in these cases I looked for a sharp drop off in open interest for options. I included implied volatility, as this gives a measure of the degree of market’s uncertainty in the outcome.

Of the initial list of 30 companies, the ones that showed particular promise, in my opinion, to foment a short squeeze are listed in the table below. Data for short interest (number of shares short divided by float) are from from March 15. “Date” refers to expiration month of peak option open interest. Implied volatility was calculated using the options calculator provided by the CBOE.

A good play on these stocks might be to create a watch list and to sit back and watch for press releases. With the high degree of short interest on these stocks, a positive clinical outcome will start a short squeeze as shorts scramble to cover. This is clearly a short term play, maybe as short as a day or two, but it should be good fun. In cases were the shorts have it right and the news is bad, well, as long as nothing is bought prior to any news, no money is lost.

Ticker - Short Interest - Event - "Date" - IV
(AGIX) - 53% - Phase 3 - July - 88%
(COLY) - 36% - Phase 3 - N/A - N/A
(CVTX) - 33% - Phase 3 - May - 95%
(NASDAQ:MNTA) - 27% - ANDA - June - 177%
(NASDAQ:NKTR) - 27% - Phase 3 - May - 40%
(NRMX) - 35% - Phase 3 - August - 186%
(PPCO) - 26% - Phase 2 - June - 80%


- Biotech Stocks Following FDA Extensions