How to Profit From Wall Street's Top Catalysts

Marc Lichtenfeld, Chief Income Strategist, The Oxford Club

Last year, I received a call from an investor relations representative who wanted to know if I'd be interested in hearing about a small biotech company with a drug candidate in Phase 2 trials.

Do Knicks fans wish they had landed Kevin Durant?

Phase 2 trials are my favorite time to get involved in a biotech company. I'll explain why in a moment. But first, a quick review of the phases of clinical trials...

The Three Distinct Phases of Clinical Trials

Before a new, experimental drug is tried in humans, it's put to work in test tubes and then animals. Once it's ready for human trials, it's tested in three distinct phases.

A Phase 1 trial is conducted with a limited number of subjects, usually fewer than 50. In cancer trials, the drug will be given to patients sometimes as a last resort.

For drugs targeting many other diseases, they're given to healthy volunteers so doctors can better understand how the drug reacts inside the human body.

If a drug is deemed safe after this period, the company will proceed to Phase 2. This trial usually consists of a few dozen to several hundred patients receiving varying dosage levels of the particular drug.

The data that's considered most accurate is from a trial that's double blind (neither the patient nor the doctor know whether the patient has received the drug) and placebo controlled (compared with a placebo or standard of care).

Some, but not most, Phase 2 trials are double blind and placebo controlled.

In Phase 3, companies test hundreds to thousands of patients. If the data proves that the drug is safe and effective, the company will usually apply for approval.

Naturally, the more patients who take part in a trial, the greater the chance the drug fails. For example, the drug may not work, or there may be unexpected side effects. This is especially common in cancer trials, where the response rates are low, even with approved drugs.

Positive results in Phase 3 can push a stock higher as investors begin focusing on approval and the sales and profits that could follow.

However, it doesn't always work that way. Many drugs with seemingly strong Phase 3 results have been rejected by the FDA for one reason or another. This can crush investors who followed a drug stock all the way to the end.

Alkermes (Nasdaq: ALKS) is a great example. Investors got their hopes up when Phase 2 data showed that Alkermes' antidepressive drug ALKS 5461 was safe and effective for patients who did not respond adequately to standard therapies... Yet the FDA rejected it, and shares tanked.

This is one reason Phase 2 is the real sweet spot for biotech investing...

Phase 2 Trials: A Profitable Time to Be Involved in Biotech Stocks

Phase 2 is often the most profitable time to be involved in a small cap biotech stock. Many times, Phase 2 results are positive. Sometimes it's because the drug works. And other times it's because the trial is rigged to provide positive results.

For example, Cel-Sci (NYSE: CVM), a company that stirs passion (both positive and negative) among biotech investors, ran a Phase 2 study on the head and neck cancer drug Multikine.

However, rather than being tested against other existing treatments, Multikine was given along with an existing treatment.

At the end of the trial, Cel-Sci boasted a 12% complete response rate. But it was impossible to determine if the two out of 19 patients who had a complete response saw their tumors disappear due to Multikine or due to the other treatment.

So why would a company do that?

To show good results in the hopes of raising additional capital.

There are also times when the science is conducted properly and Phase 2 claims are valid, but the drug isn't able to replicate results in a Phase 3 trial. Remember, a Phase 2 trial usually contains a much smaller sample size, which can easily distort results.

Very often, when a company reports strong Phase 2 results, the stock takes off, as it is the first real indication that it might be approvable. Investors get excited, potential partners begin sniffing around and the media begins to cover the drug's potential.

Even though at this point things are just starting to get promising, it's often a great time to take the money and run.

Here are a few great examples...