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ImClone and Its Implications

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Last week, I wrote a piece concerning how I thought institutional traders were assessing the Biotechnology Sector ($BTK). If you didn't read it, shame on you. Only kidding, here it is:

http://members.OptionInvestor.com/intraday/011702_4.asp

Late last Friday, it was announced that a House panel was investigating ImClone (NASDAQ:IMCL) -- the troubled biotech concern. Scroll down to the bottom of this page for more:

http://members.OptionInvestor.com/intraday/011802_4.asp

Upon further study of the issues surrounding ImClone over the weekend, I thought it would be most relevant to expand on the investigation and its implications for two reasons:

  1. I liked ImClone for a trade on January 4. I was horribly wrong. I want to know why.
  2. The revelations of the investigation may require an adjustment by traders who operate in the biotech sector as it relates to the institutional perspective I highlighted on January 17.

I like to study my losses more than my victories. I'm more concerned with managing risk than I am making money. Is that contradictory? Maybe. But if I assess risk first, I can, with much more intelligence, concern myself with profits.

With the aim of learning, I went back over the weekend and studied the ImClone trade.

Through January 4 and the $40 level, IMCL was grossly oversold. It had traded lower for 24 consecutive Os on the point and figure chart. The stock was heavily shorted into the weakness, I could see it in the options market and through price action. The premise of the trade was to capture a very short-term move, two or three days at most, for three or four points on the belief that it was due for a short-term relief rally by way of short covering and selling exhaustion.

The 3-box reversal from $40 (after 24 straight Os), which was my action point, was a highly probable trade. I've used the 3-box reversal from oversold conditions hundreds of times in the past with much success and I'll use the same method again in the future. It wasn't the method that was flawed in ImClone's case, it was my failure to fully assess risk.

The risk reared itself the following Monday, January 7, when J.P. Morgan reduced its investment rating on shares of ImClone. They saw the risks in the stock. I didn't at the time. But going back over the press releases, it was clear. Yes, I very much dislike hindsight. As Mr. Passamonte is fond of saying, "Hindsight is the bane of man's existence."

ImClone was incredibly ambiguous in the press releases that followed the rejection of the application for its cancer drug. I don't blame the company, because companies do those things. The problem lies in the way the FDA communicates its disapproval of the drug development process. The FDA doesn't release its findings to the public, let alone the SEC. The FDA leaves it up to the company to disclose the development process. As a result, ImClone didn't fully disclose the severity of the problems with its drug to investors, hence the investigation. The warning signs were there, however subtle, they existed.

Secondly, the investigation into ImClone brings into question the longer-term perspective on the biotech sector. Clearly, there's more risk in the sector. And either traders need to be compensated for that risk, or they'll walk away, resulting in a lower premium on biotech stocks with products under development. I think we're seeing some of that valuation compression in the likes of Millennium (NASDAQ:MLNM), Vertex (NASDAQ:VRTX), Protein Design Labs (NASDAQ:PDLI), ICOS (NASDAQ:ICOS), and Abgenix (NASDAQ:ABGX) to name a few.

Moreover, investment in developing biotech concerns may be approached more cautiously. The ImClone debacle is a pertinent example. Bristol Myers (NYSE:BMY) invested about $2 billion in ImClone for a 20 percent stake in the company's cancer drug. At the time, the investment by BMY was thought to have set a new precedent in the way biotech and pharmaceutical companies co-existed. But the investment in risky endeavors, like ImClone has proved, may bring about a different way of thinking about biotech stocks.

The smaller biotech companies need the larger pharma companies for the latter group's marketing and distribution prowess, plus the investment of working capital. Without the aggressive investment policies of the big pharmas, the result could be more downwared pressure on valuations in the biotech group.

In conclusion, take the ImClone trade experience and learn from it. I, with much certainty, can say that a similar situation will develop in the future with so many young biotech companies in the market. Take the education from the ImClone loss and use it to win in the future.

Additionally, the institutional perspective on the biotech sector may have shifted, (is shifting) in light of the developments surrounding ImClone. The way risk is measured and managed in the biotech sector has changed in the last week. Yes, the $BTK is higher by 1.41 percent today, but this conclusion concerns the bigger picture, not the short-term. Please make that distinction.

(I like to provide content that has continuity. That's why I keep going back to ImClone among others. I think by reviewing and re-reviewing a particular trade or market thesis, we can really start to understand the hows and whys with the aim of applying that learning towards future successes in the market. I can't promise, but I think I've finally put ImClone behind.)

Eric Utley
Option Investor

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