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Trading Techniques: FDA Drug Approvals

Trading Techniques: FDA Drug Approvals
April 03
17:06 2012

Day traders and short-term traders are constantly seeking techniques that exploit certain predictable patterns in equity price movements. You might expect that a significant event such as approval of a new drug by the FDA would be a fundamental short-term driver of a stock, and you might further expect that approval would specifically result in a rising share price. In truth, the first assumption is somewhat accurate; the second, even less so.

To address the second assumption, the price movements after an approval announcement are not reliable enough to be a worthwhile trading pattern in most cases. The breakeven failure rates are 34% for an upward breakout and 39% for a downward breakout. As for the first assumption, following an approval fully half of these companies see a downward breakout. Of the stocks that do move up, 42% reverse within a week. So, while such a significant business event would seem to be tailor-made for a predictable pattern, that is sadly not the case.

There is, however, an inverted-J pattern that sometimes forms after drug approvals that can be traded, which is what we’ll examine here. You should first understand, however, that “FDA drug approval” in this context means a major drug; large multi-billion dollar pharmaceutical companies routinely have minor drugs approved, since changing the form (liquid or cream vs. pill, for example) or dosage of an existing drug requires a new FDA approval. Those approvals are merely routine business and will not even make a blip on the market’s radar. In other words, the approval needs to be a significant event.

The J-pattern is signaled by an intraday price swing on the day of or after the approval announcement that is two to three times the typical range seen in the past 30 days. Volume should also be well above the 30-day average. Wait to see the direction of the breakout. If the stock trends downward immediately, ignore it, as it is not a candidate for this pattern. If it breaks upward, however, expect to see a climb to a gradually slowing peak (which forms the loop of the inverted J) that takes three to six weeks. (If the climb takes longer, the pattern has been violated and you should ignore the stock.) Once the stock peaks, it will then begin a protracted decline.

You should be able to draw a trendline along the intraday lows during the initial climb, and naturally that line should slope fairly steeply upward. Once the stock breaks below that trendline, the decline should begin at any time, and that is your signal to short the stock. Nearly half—42%—of  upward-breaking stocks will hit their peak within seven days; 28% will take more than 70 days. For longer periods of two to nine weeks, the percentages of stocks that peak are in the single digits. That is why you should ignore a climb that fails to peak within six weeks.

Exactly how far the stock will decline after peaking is difficult to predict, and in many cases it will not decline all the way to its starting point (that is, the price on the announcement date). That is another reason this is not a highly-recommended trading event. However, you are generally safe in anticipating a 15% decline from the peak.

Once it is clear that the stock is breaking up, you can also choose to take a long position, but understand that this pattern moves fairly quickly—as we just discussed, almost half will peak within a week. If you are more aggressive, you can certainly go long and then, when signaled by the breach of the trendline, exit the long position and enter a short one.

In either case, bear in mind that short-term trading requires discipline to be successful. Don’t let greed tempt you into remaining in a position too long, or you may find yourself losing all of your gains and more.

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