Investing in Biotech Stocks: Use This One Simple Strategy to Limit Risk and Maximize Gains

It's a common thought that investing in biotech stocks is just too risky for the average investor - but that's not the case.

investing in biotech stocks

It's true that biotechnology stocks can be very volatile - especially when companies have developmental drugs going through clinical trials - so they aren't the right stocks for every investor. But when investors are able to limit risk, they can find their portfolio's biggest profits from biotech.

Take the drug stock Aegerion Pharmaceuticals Inc. (Nasdaq: AEGR), which caught the eye of Money Morning's BioScience Investment Strategist Ernie Tremblay in August 2012 at a price of $17.46. A little over a year later, the stock was worth $97.24, for a gain of 457%. And with this one investing strategy, investors were protected from any sudden price drops - while still keeping their profits.

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The Most Effective Way to Reduce Risk When Investing in Biotech Stocks

Biotech stocks can move fast. When news breaks that a company is close to getting a treatment approved, it's not surprising to see the share price jump 20%, 50% - or even double - in one day.

That's why it's absolutely necessary to employ a gain-protecting strategy when investing in biotech.

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The best investment tool that Tremblay recommends is a trailing stop. Trailing stops are stop-loss orders that move with a stock's gains.

"Trailing stops set you up to sell automatically when the stock drops a defined percentage from the highest level it has hit since you owned it," Tremblay said. "The stop-loss level is 'trailing' because it follows the share price up. If the share price continues to run higher, your trailing stop will follow it."

Let's say an investor sets a trailing stop of 25%. That guarantees that he or she won't lose more than that 25% on the investment. On the rare occasion that the stock immediately tanks, the investor has only lost 25%, even if the stock posts a much bigger loss.

If the stock gains 100% and then corrects all the way back to just a 30% gain, the trailing stop would have kicked in when the share price fell to the 75% gain mark.

Now, if a stock drops extremely fast, the order may not go through at exactly the right percentage. But the trailing stop will limit the damage in a crisis situation.

There are a couple of benefits of trailing stops in all sectors, not just biotech.

"First, trailing stops keep you from selling your stocks during powerful uptrends," Tremblay continued. "They also prevent small losses from becoming catastrophic losses."

Tremblay said the most important thing about trailing stops is that they encourage smart, calculated investing.

"Trailing stops keep emotion out of your investing decisions by setting a pre-determined level at which to sell," Tremblay said. "Despite our best intentions to be dispassionate about how we handle our money, in the bioscience sector, it's very easy to fall in love with a stock. It may be hard to let go of a stock, even when all the numbers are screaming at you to move on. Setting a trailing stop takes that decision out of your hands."

While we typically use a 25% trailing stop on investments, Tremblay said it's okay to increase to 35% in biotech because of how much these stocks move.

"There's slightly more at risk with a 35% trailing stop, but since there are so many ups and downs in these stocks' prices, I believe it's worth it," said Tremblay.

What to Read Next: Ernie Tremblay has found a biotech stock with breakout potential. It's already soared 700%, but still has room to run. And thanks to a recent media blunder, it's trading at a discounted price right now...