One of the most exciting and lucrative avenues of stock investing is in the biotech arena. It can also be one of the most dangerous.
The sector focuses on developing and marketing lifesaving drugs and other medical breakthroughs. These products can have profound constructive effects on the world. Not only have many investors built fortunes by investing in biotech, but it feels good to know you're helping to fund such positive research and development.
Tiny biotech companies can make their investors a fortune when they're acquired by their larger brethren or bring a revolutionary product to market. Short-term profits can abound when these companies make bullish product announcements or pass Food and Drug Administration (FDA) requirements, as well as for a host of other reasons.
The Dangerous Side
However, biotech companies are among the market's most inherently volatile stocks. Many of these companies don't generate revenue and are burning cash like crazy on research and development. It's a race between this burn rate and the company's ability to get its products to market (or raise more cash to continue operations).
In other words, early stage biotechs are highly speculative. As products are brought to market, the company grows stronger, thus increasing stability and long-term upside potential.
However, the majority of biotech stocks wash out and never actually get products to market. The primary reason for this is the FDA's strict testing regime for safety and effectiveness. Passing or failing FDA tests results in investor excitement, which drives the shares' volatility. It is within this volatility that fortunes are made and lost.
The Good News
While most investors invest in biotech stocks with the hope of a breakthrough medical product to propel shares higher, there is a much smaller group of savvy investors who earn fortunes from the failure of biotechs.
If you've read my recent article on shorting stocks, you have a general idea how to profit when stocks drop. Due to their volatility and low success rate, biotechs make ideal stocks to short. The trick is to find biotech stocks that are about to drop in price.
Here are three basic steps for finding biotech stocks primed to collapse:
|1. Technical Screening|
|Most investing platforms provide technical price and sector screening tools. First, I screen the biotech sector for stocks trading for less than $10 that have gained or lost the greatest percentage amount over the past day for short-term trading or the last week for long-term short-side investing. Then I take the three biggest gainers and losers and place them on my list for further research.|
|2. Technical Charts|
|Next, I look at the daily chart patterns of the six potential short candidates. On the percentage gainers, I look for current double top formations, gap moves higher, a sharp move higher without a significant volume increase, and any other common technical patterns that indicate exhaustion on the upside.
On the three smallest percentage losers, I look for technical reasons for the move to continue on the downside. I especially like to see a gentle slope downward, which points toward sharper losses to come when triggered by a catalyst.
Remember, we are not looking at the past for sharp moves downward that may be followed by a bounce higher; we want to be short the stock prior to the pending downward plunge. A slow decline indicates a company that may be burning cash but not producing any bullish news. While it's not a guarantee, news and test results tend to have greater odds of being negative than positive, which means a company's plunge into the abyss makes more sense than betting on a turnaround.
|3. The Fundamental Catalyst|
|Finally, I look for a pending fundamental catalyst to send shares lower. Events such as a pending FDA test, management shakeups, negative product news, trouble raising money, new stock offering pending, and one or only a few products in the pipeline may be signaling an imminent drop in share prices.|
Risks to Consider: Shorting can be dangerous as short squeezes can occur to companies in even the most dire straits. In addition, a bet on bad news can easily be wrong as good news can and does occur. Always use stop-loss orders and diversify when investing either long or short.
Action to Take --> Practice using technical stock screeners to locate the most likely biotech candidates to short. Study the daily charts of biotech stocks that have collapsed in price. Look for recurring patterns that occur prior to the plunge. Remember, shorting is both an art and a science. Start with a small size of maybe 100 shares for your first biotech short trade. Add to your short positions as you gain confidence.