My template for trading Biotech stocks
Results of clinical trials can be existential for pre-revenue companies. Here is how I trade that with options.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
To understand what follows, it will be helpful if you have studied options and performed research on the biotech sector before, but it is not required. You simply need an open mind and a healthy amount of curiosity. It would also be beneficial if you familiarize yourself with my previous work on derivatives. This article does not directly build on those linked below, but they are helpful context to understand how I think about convexity and volatility.
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I haven’t told you before, but I actually spent the first years of my career assisting portfolio managers in a mutual fund company as a research associate. One of them ran the firm’s healthcare and biotechnology products. It was a mysterious, but fascinating world that seemed to be detached from anything else in the markets. My main task was to build and maintain the financial models for the funds’ holdings, which involved running risk-adjusted NPV calculations for compounds in clinical trials. I did this with the help of sellside research analysts because it’s a challenging task, particularly for a science outsider like me. You need a good handle on the market opportunity and how the drug candidate fits in.
When an important clinical trial came to its conclusion or reached an important milestone, investors got very nervous and excited. This was nowhere as visible as in the option chain which got incredibly juicy. I remember very well how grumpy my boss got when he wanted to place a directional bet based on our research only to realize that the options were priced consistent with 200% or 300% annualized volatility stacking the odds against us. It was hard to comprehend for a newbie like me how such an option pricing was even mathematically possible. I did not really understand what the implied volatility priced into an option represents.
Today, I understand option mechanics much better and I believe I have identified a promising systematic trading strategy on these binary events. I have been using this as a little side hustle for a while and so far it seems to work. This strategy is actually surprisingly simple, but there are good reasons why it works anyway.