If you think stocks can act crazy around earnings releases, as Bachman Turner Overdrive sang:

You ain’t seen nothin’ yet
B-B-B-Baby, you just ain’t seen nothin’ yet
Here’s something that you never gonna forget
B-B-B-Baby, you just ain’t seen nothin’ yet

That’s because for biotech stocks there’s an event even more important and volatile than the release of quarterly results, especially when you consider some biotech companies don’t have earnings or even revenue.

The most important day for a biotech company is the PDUFA date (pronounced puh-doo-fuh). It stands for Prescription Drug User Fee Act. The PDUFA date is the day the FDA votes to approve or reject a drug. Sometimes, the FDA will rule before the announced PDUFA date, but it’s the day by which a decision is expected.

As you can imagine, an approval or rejection can send a biotech (especially a small one) soaring or plummeting.

For example, in 2011, while three companies were furiously competing to get their obesity drugs approved and on the market, Orexigen Therapeutics‘ (Nasdaq: OREX) Contrave was rejected by the FDA. The FDA wanted more testing done over concerns of cardiovascular side effects. The result was a 72% shellacking in the stock price in one day.

The company is conducting those trials and plans on resubmitting to the FDA with the hopes of an approval in 2014.

On the other end of the spectrum, Arena Pharmaceuticals (Nasdaq: ARNA) soared 74% in May on recommendation of approval by an FDA advisory panel. The stock went on to nearly double from there after it was formally approved in June.

Managing Expectations

Just like an earnings report, the stock will usually respond not only to the news, but to what investors were expecting. If an FDA approval is widely expected, chances are the stock will have run up in anticipation of the event. Once the FDA gives the drug the green light, the stock could even sell off on the news.

Conversely, if trial results were not spectacular or if an FDA review panel did not recommend approval, when the drug is rejected, it may be a non-event because a denial may already be baked into the stock price.

Three Steps for Playing the PDUFA Date

• Know the expectations – Do your homework as to whether Wall Street is expecting an approval or rejection. See what analysts and bloggers are saying. Also check if there’s been an FDA panel review. The panel makes a recommendation to the FDA, which the FDA does not have to follow, but often takes into consideration. If the FDA goes along with the recommendation of the panel, it could mute the reaction in the stock. If it surprisingly goes in the opposite direction, the stock could have an exaggerated move.
  
• Risk on – This is definitely a risky trade. If the stock goes against you, it could do so drastically. It’s not unheard of for a stock to gap down 50% on bad news from the FDA. If you have a stop in place, it’s not going to get you out at your desired price. Be prepared to lose big if the FDA does not rule the way you want it to. Be able to handle the outsized risk before trading biotech stocks ahead of a PDUFA date.
  
• Consider options – Options may be the cheaper way to play it, but remember that once the FDA makes its decision all of the volatility will be sucked out of the options price. That being said, if the stock makes a big move, you’ll probably still make money (possibly a large amount), but an option before a PDUFA date is going to be expensive.
  

Since I just told you the options lose most of their juice immediately after the PDUFA date, you might be inclined to sell some options to take advantage of the higher volatility that’ll diminish on a specific date. I don’t recommend it. You certainly don’t want to sell a put. If the drug is rejected and it’s a small- to mid-cap biotech, you probably don’t want to own the stock, even at the lower price. The company may have to run another costly trial if it wants to try to get the drug approved again. Or it may scrap the whole program.

If you’re going to sell calls, then you’re putting a cap on the amount you can make if the stock moves sharply higher. If you’re going to speculate on a small-cap biotech, then speculate. Swing for the fences. If the risk is too much, either take a smaller position or don’t play in the sector.

Biotech investors and patients eagerly await PDUFA dates, as the results announced on or before those dates can change people’s lives – both from a medical and a financial perspective. Be sure to understand the risks and potential rewards with owning a stock near its PDUFA date.

Here are five upcoming PDUFA dates:

Good investing,

Marc

*The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Wall Street analysts.