The Art of Setting Stop Losses in the Healthcare and Biotech Sectors

Marc Lichtenfeld
by Marc Lichtenfeld, Chief Income Strategist, The Oxford Club

The Art of Setting Stop Losses in the Healthcare and Biotech Sectors

by Marc Lichtenfeld, Healthcare and Biotech Analyst

Wednesday, May 26, 2010: Issue #1268

What's the first thing you should do after you buy a stock?

  • Some celebrate.
  • Some tell their friends.
  • Many anxiously watch the movement of the shares, sweating over every tick up and down.

None of these options are right.

By all means, pat yourself on the back and tell people. But only do it after you've established a stop-loss point for the trade - and set it...

Two Purposes for Setting Stop Losses

At Investment U, we're huge advocates of using stop-losses - and adhering to them. And most trading platforms will automatically sell a stock for you once it hits your designated stop level. This takes all the emotion out of the sell decision - a valuable tool, given that many investors have trouble pulling the trigger when it's time to sell. This usually results in further losses or giving back some gains.

In our portfolios, we have stops set on almost all our positions. This serves two purposes:

  1. Bye-Bye, Emotions: As I mentioned above, the emotion is removed from the sell decision and we're not tempted to hang on, in hope of a revival or trying to snag another 0.2% gain.
  2. Early-Warning System: We always note the stop level for the trades that we recommend to subscribers. That way, everyone knows precisely what action to take without having to receive an update in the event that a stock or the market tanks. (Of course, we still send out instructions when the stops are hit, but subscribers don't have to sit glued to their computers, waiting for an e-mail from us).

However, there is one area where I usually don't use stop-losses. And the answer might surprise you, given that it's one of the most volatile segments of the market. Read on to find out why...

Small-Cap Healthcare and Biotech Companies: No Products, No Problem!

In my service, I recommend small-cap healthcare and biotech companies.

The small-cap market is generally more speculative, as you're dealing with smaller companies, sometimes with unproven products and less trading volume.

And in the small-cap healthcare and biotech world, some companies don't even have a product at all! They're companies that have potentially groundbreaking new drugs/therapies in clinical trials, aimed at curing horrible diseases like brain cancer or melanoma that has spread to the liver, but don't have anything to sell yet - and may not for several more years.

In many cases, these healthcare stocks have what I call a "binary catalyst," which has the power to move the shares very sharply in one direction or the other.

These catalysts include clinical trial data, which will either show that a drug is effective or not, or whether it's safe. And if a drug makes it all the way to the Food & Drug Administration's (FDA) approval process, the stock's next move hinges on the FDA's "yes" or "no" decision. It's not unusual to see a stock pop by 20%, 40%, even 100% on important clinical data or FDA approval.

  • Just yesterday, for example, Neurocrine Biosciences (Nasdaq: NBIX) jumped by 50% on the open after its gynecological drug, Elagolix, hit mid-trial targets. The move came as the Nasdaq plummeted 3% after the open. The stock closed up 24.5% and is up a further 22% so far today.
  • Another stock that has performed superbly for us is Delcath Systems (Nasdaq: DCTH). Shares are currently up 195% from our recommended entry price of $5.25. And like Neurocrine, it also enjoyed a huge surge after the release of good news.

Back in mid-April, the stock was trading around $10 when positive preliminary Phase III data came out on its PHP System (a device that isolates the liver from the rest of the body, allowing high doses of chemotherapy to be administered directly into the liver without affecting other areas).

Result? The stock opened at $14.25 the following day and climbed as high as $16.45 a few days later.

Of course, the reverse is true. When it comes to healthcare investing, some stocks can easily see their values slashed in half when things don't go their way.

But that's a risk I'm willing to take with these types of stocks. So how does this tie into stop-losses?

If You're Gonna Swing, Take a Big One

If I've done my research and think I've got a company that has the next great drug for cancer or a rare disease, it doesn't make sense to put restraints on it that could result in the stock getting stopped out due to "market noise."

After all, if the market tanks due to the European financial crisis, that doesn't make the slightest difference to the clinical trial results of a small-cap cancer company.

Think of it like this: If you're swinging for the fences, take a big swing. When did you ever see Mark McGwire bunt? He was in the batters box for one reason and one reason only - to smash the ball 450 feet into the upper deck.

His team had plenty of other guys to get on base, pitch and play defense. McGwire was there to hit steroid-enhanced home runs. And that's what he did.

To Stop or Not to Stop? Here's the Answer to the Question...

Take a look at your investment portfolio.

If you've diversified and allocated your assets properly, you've probably got a good mix of growth stocks, value stocks, income-producing stocks, mutual funds, bonds, etc.

But do you have any small-cap healthcare or biotech stocks?

If you do, make sure you know when you should and shouldn't set stop-losses on these stocks. For example...

  • When Not to Set a Stop-Loss

It makes sense to include potential "swing for the fences" blockbusters. But because you're banking on a specific event to jumpstart the stock, you need to let the stock do its thing. That means not stifling it with a stop-loss.

That said, keep your investment sensible. Never risk more than you can afford to lose.

Keep in mind that if the drug fails or gets rejected by the FDA, the stock will plummet on the news. And chances are you'll take a hit, too. But by not placing a stop, we're trying to avoid getting shaken out due to unrelated market events.

  • When You Should Set a Stop-Loss

So does that mean you should never set a stop-loss on a small-cap healthcare or biotech company? Of course not.

We have stocks in  portfolios that are growth and earnings stories. In those cases, we absolutely set a stop, as we're not waiting for one singular event to occur. On other occasions, our stock jumps after the event takes place and we set a stop in order to protect gains while we try to let the winner run.

But in cases where it's a "binary event" that you're waiting for, give yourself the green light to swing for the fences. It's why you're in the stock in the first place.

Hoping your longs go up and your shorts go down.

Marc Lichtenfeld

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