• Facebook
  • Twitter

How to Profit When Test Results Sink a Biotech Company

How to Profit When Test Results Sink a Biotech Company

Investors in biotech companies are often buying hope. There’s a little more to it than that but they are buying into the hope that the company will successfully navigate the drug approval process. This can be a long and difficult process.

By some estimates, it can take more than 8 years to bring a drug to the market. The process includes three distinct phases of testing with multiple levels of review in each stage.

New drugs can fail at any stage in the process. And, failure can be absolutely devastating to a company. Investors can see hundreds of millions of dollars in market cap destroyed in minutes as traders work to assimilate the news.

Sage Therapeutics Disappoints in Stage 3

Sage Therapeutics (Nasdaq: SAGE) announced that its drug to treat a severe and life-threatening form of epilepsy failed to meet the main goal of a late-stage trial.

Sage Therapeutics is a clinical-stage biopharmaceutical company committed to developing novel medicines to transform the lives of patients with life-altering central nervous system (CNS) disorders. Sage has a portfolio of candidates targeting critical CNS receptor systems, GABA and NMDA.

Sage’s lead program is brexanolone (SAGE-547) for the treatment of super-refractory status epilepticus (SRSE), a rare and severe seizure disorder, and is in Phase 3 clinical development for postpartum depression. Sage is developing its next generation modulators, including SAGE-217 and SAGE-718, in various CNS disorders.

Before the market opened on Tuesday, Sage reported top-line results from its Phase 3 trial of brexanolone.  The study did not meet the primary endpoint, comparing success in weaning of third-line agents and resolution of potentially life-threatening status epilepticus with brexanolone compared to a placebo when added to standard-of-care.

The drug helped 43.9% of patients, not much better than the placebo which helped 42.4% of patients.

Demographics and baseline characteristics were well-balanced between treatment groups in the study. Due to the severity and complexity of their underlying medical conditions, serious adverse events commonly occur in patients with SRSE and were similar in frequency and type between the two treatment groups.

SRSE, a life-threatening persistent state of seizure that does not respond to first-, second- or third-line treatments, is a neurological emergency that may cause death or life-altering outcomes. There are no treatments for SRSE currently approved by the FDA.

Status epilepticus (SE) is an acute medical emergency of persistent, unremitting seizure lasting greater than five minutes. An SE patient is first treated with benzodiazepines, and if no response, is then treated with other, second-line, anti-seizure drugs.

If the seizure persists after the second-line therapy, the patient is diagnosed as having refractory SE (RSE), admitted to the ICU and placed into a medically induced coma. Physicians typically use anesthetic agents to induce the coma, along with antiepileptic drugs in an attempt to stop the ongoing seizure, in RSE patients.

After a period of 24 hours, an attempt is made to wean the patient from the anesthetic agents to evaluate whether or not the seizure condition has resolved. Unfortunately, not all patients respond to weaning attempts, in which case the patient must be maintained in the medically induced coma.

At this point, the patient is diagnosed as having SRSE. Sage estimates that there are between 25,000 and 41,000 cases of SRSE in the U.S. each year. Currently, there are no therapies specifically approved for SRSE.

The company is also testing the same drug in post-partum depression, or PPD, with results of a two late-stage trials in such patients expected before the end of the year. But Tuesday’s failure is raising some doubts about whether that trial will succeed.

Analysts at Leerink Partners said the despite the trial fail, they still give the drug a 75% chance of success in postpartum depression.

“In our view, much of how SRSE is perceived by the Street (and priced-in to the stock) will depend on whether or not the failure at all dampens investor confidence in what are a handful of small samples of data,” analysts wrote.

“This is likely to become a polarizing issue, though. We believe the vast majority of SAGE’s out-performance in 2017 was driven by indications other than SRSE. We still think that PPD … should stand on its own merits given that the phase II data are placebo controlled, show a large signal (and) are published.”

The Stock Reacts With a Predictable Decline

Traders seem to have expected positive results and built these expectations into the stock’s price. Shares of SAGE had more than doubled off of its January lows.

Tuesday’s selloff indicates traders are reassessing the company. Now, it seems as if the trend in SAGE will be down. Even if the stock doesn’t decline much, in the short term, SAGE seems unlikely to rally sharply given the bad news.

This means traders should consider using an options strategy known as a bear put spread to benefit from the expected price move.

This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.

Source: The Options Industry Council

A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.

The Trade Specifics

The bearish outlook for SAGE, at least for the purposes of this trade, is a short term opinion. In the long run, this stock could move significantly higher. But, for now, SAGE is likely to consolidate or drift lower for a time.

To benefit from a potential selloff, traders can buy put options. A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expires. While buying a put is possible, it can also be expensive.  The risk of loss when buying an option is equal to 100% of the amount paid for the option.

To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.

Specifically, the October $75 put can be bought for about $6.20 and the October $70 put can be sold for about $4. Because each contract covers 100 shares, this trade will cost about $2.20 to enter, ignoring the cost of commissions which should be small when using a deep discount broker.

The maximum loss is experienced if SAGE remains above $75. In that case, both options would expire worthless. That would result in a loss of $220, the capital outlay at the time the trade was opened.

The maximum gain on the trade is equal to the difference in exercise prices less the premium paid, or $2.80 in this trade ($5.00 – $2.20 = $2.80). Again, since each contract covers 100 shares, the maximum gain is equal to $280.

Most brokers will require you to maintain a deposit equal to the equal to the risk on the trade as the margin requirement, or $220 to open this trade.

That is a potential gain of about 125% on the amount risked in the trade. This trade delivers the maximum gain if SAGE closes below $70 when the options expire. If SAGE closes between the exercise prices of the two options on that day, the gain will be less than $2.80.

Small traders may find this strategy to be attractive. Put spreads can be used to generate relatively high returns, in percentage terms, on small amounts of capital. When options expiring in the next few weeks are used to create the spreads, trading capital can be compounded several times a year.

There are risks to this trade. Those risks, in dollar terms, are relatively small, about $220 for this trade in SAGE. If the trade delivers its maximum potential gain, an investor risking $220 would more than double their money.

Repeated monthly, successful trades using this strategy could allow a small trader to increase their capital rapidly. That would be difficult to do without using options and it will be difficult to do using options. But, large gains for small investors are possible, especially when risks are controlled and limited.