Understanding Binary Catalysts: A Brief Guide For Biotech Investors

by: John Engle

Binary catalysts are the primary drivers of developmental biotechs' stock prices.

There are a variety of catalyst types, some of which can be anticipated and some which come as surprises to everyone involved.

Long-term successful biotech investing strategies have to build in deep understandings of how stock prices move before, during, and after various catalysts.

This article provides a brief guide to approaching catalysts with confidence.

This article was co-authored by Stepan Lavrouk. Stepan is an investment analyst with Almington Capital.

We have written extensively on Seeking Alpha about a range of biotech stocks. But we have also spent some time addressing the activity of biotech investing itself. In previous articles, we have covered the importance of psychological fortitude in such a volatile and binary event-driven sector, as well as the need to stay focused on the catalysts rather than day-to-day price movements. We have also discussed the dangers of trading naked options, a habit of numerous retail biotech traders, many of whom can keep a winning streak going for quite a while before getting buried by an unexpected catalyst or big move.

In this article, we will tackle another broad topic that should be of interest to biotech investors. Specifically, we cover the various advantages, disadvantages, risks, and rewards of trading before and after various types of catalyst. These are the events that can often dictate the future of these small companies. Understanding them and how the market reacts to them is critical to understanding how to prosper as an investor in the sector over the long-run.

Trading Up to the Catalyst

The Trump administration’s FDA has been significantly more willing to green-light new drugs than President Obama’s ever was. As well as providing a sector-wide boost to the biotech space, this has resulted in approval becoming the default assumption for a lot of investors. This phenomenon provides a relatively low-risk strategy: Identify a small-cap company with an important PDUFA (or other catalyst) coming up, then look for an upwards drive in price in the weeks preceding the catalyst date.

Generally, this increase in price is modest and takes place over an extended period of time (a month or more), as the company gradually attracts the attention of investors and traders. However, there are also examples of companies performing spectacularly well in very short spaces of time, for instance, Apricus (APRI). In the week preceding its February 16th PDUFA for Vitaros, the company’s erectile dysfunction cream, the share price skyrocketed by an astounding 42%.

Trading up to a catalyst, as investors take positions in hopes of a bump before or after the event, can prove very profitable, especially in relatively under-followed stocks that garner sudden bursts of attention as a clinical trial announcement or PDUFA deadline approaches.

Holding Through a Catalyst

The other side of this coin is that precisely because approval is so often priced in pre-catalyst, there is no post-approval pop up in price. In fact, "selling the news" appears to have gotten more aggressive lately, reducing the advantages of holding positions through catalysts with a high probability of success.

Larger players will sometimes take profits immediately after the catalyst, which can spook retail investors and day traders, for whom the sell-off can understandably seem counterintuitive. This leads to a certain amount of panic selling, further driving the share price down. For this reason, holding positions going into catalysts in these circumstances is inadvisable. That said, the sell-off can provide a good entry point for investors who happen to be late to the party, but still view the company as a good long-term prospect.

Not all treatments are inevitably destined for approval, however. Apricus again serves as a useful example, though this time as a cautionary tale about the dangers of holding into an uncertain catalyst event. The FDA did not actually give Vitaros the all-clear. For a small-cap company with a limited pipeline, this is devastating: Apricus lost more than 67% of its value off the back of this announcement.

Conversely, getting the thumbs-up for a drug for which approval is not priced in is a massive boon. Shares of Dynavax (DVAX) soared from $9.25 to $15.85 back in July when the FDA’s Advisory Committee voted resoundingly in favor of approval for Heplisav-B, its novel Hepatitis B vaccine that had twice before received an FDA CRL.

What the above stories demonstrate is that holding into a catalyst can be a highly risky play, particularly since it is impossible to know precisely what the regulators think. The lesson is this: Proceed with caution.

The Challenge of Open-Ended Catalysts

The experience of Adamis (ADMP) is illustrative of the frustrations inherent to investing in the biotech space. As we discussed elsewhere, the company has yet to secure a commercial partner to market Symjepi, its epinephrine injector. Investors have been left in the dark for longer than anyone anticipated, which has elevated the importance of the eventual announcement. The stock has traded down 32% from its 2018 high of $4.85 as investor worries have piled up. Confirmation of a commercialization partner would obviously provide a lift for the share price.

The dilemma with catalyst events like this is that we do not know when they will occur. As a result, these are higher risk opportunities, not necessarily because price volatility will be significantly greater than it would be with a catalyst with a defined date like an FDA meeting; rather, risk is increased because cash is tied up indefinitely and an investor pays the opportunity cost of not being able to park it elsewhere.

There are two conclusions that can be drawn from the Adamis story. Firstly, if you do decide to play this type of catalyst, limit your exposure to a greater degree than you would with an event with a PDUFA (all other things being equal). Secondly, be prepared for these events to occur when investing in this space more generally.

Dealing with Surprise Catalysts

As you would in all things, expect the unexpected. Events like the November 13th announcement of a secondary offering by Synergy Pharmaceuticals (SGYP-OLD) can seriously blindside investors. This news, in no way telegraphed in the preceding earnings call and guidance, has seriously undermined investor faith in management and has been drag on share price ever since - at time of writing, the stock was trading at $1.78, a far cry from its year high of $4.74.

What can biotech investors do to insulate themselves from such nasty surprises? Well, by their very nature, surprises are difficult to prepare for. Due diligence and a diversified portfolio can go a long way towards reducing risk, however.

Furthermore, there are a number of features inherent to the small-cap biotech space that should make investors be more risk-averse than they would be when dealing with other markets. Firstly, since the companies in question are small, and tend to trade at lower share prices, shocks have a comparatively greater effect on price than they would for bigger firms. Secondly, the companies we are dealing with have, at best, a handful of drugs, with a flagship treatment usually having outsize importance. As a result, surprise events, like the failure of a drug to show efficacy in a study, will affect valuation to a greater extent.

Investors must be prepared to move quickly when surprises happen, and to identify when they represent an overreaction (and thus an opportunity) or a signal to cut losses and get out.

Investor’s-Eye View

This article has attempted to distill some useful insights about the nature of various biotech catalysts and how investors, speculators, and traders can play them to their profit. It is a volatile game, but one that can be won through careful planning, smart diversification, paying close attention to details, and watching religiously for any and all new developments. Even then, surprises can happen. But these tools and strategies should help investors win out in the end.

Disclosure: I am/we are long ADMP, SGYP, DVAX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.