Clinical-stage biotech stocks have a well-earned reputation for being outstanding growth vehicles. In the past 12 months, for instance, the liver disease specialist Madrigal Pharmaceuticals (NASDAQ:MDGL) and the cancer company Mirati Therapeutics (NASDAQ:MRTX) have produced life-changing gains for early investors. 

MRTX Chart

MRTX data by YCharts.

For every Madrigal or Mirati, there are literally dozens of other developmental biotechs like Novavax (NASDAQ:NVAX) that have essentially wiped out investors brave enough to buy their shares. Clinical-stage biotechs don't have to be an "all-or-nothing" investing strategy, however. Far from it. 

Because of the enormous volume and volatility that comes with this cohort of equities, I've found that clinical-stage biotechs lend themselves particularly well to a three-pronged investing strategy that can produce enormous gains with far less risk than a buy-and-hold approach. Below, I outline the basics of this strategy. 

Image showing molecules linked together, and vials containing DNA double helices.

Image Source: Getty Images.

Find a hidden gem

As you might expect, stock selection is absolutely key to this strategy. If you choose the wrong stock, there's little you can do to change course later on. So take your time to identify the right equity.

Which traits should you be on the lookout for? In my experience, the ideal candidate will have four core characteristics:

  1. A pipeline that sports at least one blockbuster candidate or a drug discovery/development platform capable of attracting a larger partner. 
  2. Equally as important, the company's pipeline should have at least one major data readout or regulatory catalyst on the horizon within a year's time. 
  3. Adequate capital to build value through pipeline maturation -- inadequate capital leads to serial dilution and value decay over time.
  4. An attractive long-term valuation. History shows that two of the best places to go bargain hunting in biotech is by checking out companies with clinical or regulatory setbacks that have crushed their valuations or recent initial public offerings.

Madrigal and Mirati are the perfect embodiment of these four traits. Both companies experienced significant setbacks that caused their valuations to dip initially, but they each had other assets in the pipeline capable of sparking a rebound. They also had enough capital to advance their pipelines before having to issue equities and dilute their shareholders in a meaningful way. 

Put simply, the combination of high-value clinical assets and adequate capital can be a powerful combination when it comes to value creation in this space. Biotechs that lack either of these characteristics may struggle to realize their potential as growth vehicles. 

Protect your capital (take profits!)

I think one of the most common mistakes investors make when investing in these high-risk equities is failing to take profits after a large move upwards. While it can be tempting to buy and hold for the duration, these stocks are known for their wild price swings and prolonged downtrends following any type of setback. In other words, you need to make hay when the sun is shining. 

Novavax serves as a great example here. In the run-up to the biotech's initial data readouts for its respiratory virus vaccine, Novavax's shares were going bonkers, thanks to the vaccine's megablockbuster commercial opportunity. When the vaccine's midstage data revealed a less-than-ideal efficacy profile, however, shareholders hit the exit button in droves. And a late-stage failure for the vaccine would eventually put the final nail in the coffin, causing Novavax's shares to lose over 80% of their value the following year. 

The take-home point here is not to get greedy. If you buy stock in a developmental company that has a compelling pipeline and the capital to develop it, there's a better-than-average chance that its shares will run, and run hard at some point. And they often more than double in value prior to even reaching a material catalyst. Novavax's shares, for instance, gained an incredible 126% in the 12 months before announcing any major data for its respiratory vaccine candidate.  

My golden rule in this type of situation is to sell half of my position once a clinical-stage biotech doubles in value from where I originally bought it. Again, the trick, if you will, is to pick a stock that is trading at a compelling long-term valuation well ahead of any clinical or regulatory catalysts -- but that has the funding to execute on its business plan. That way, you can take profits once a surge in share price takes place and still remain in the game for the long haul.

The point is that there's no logical reason to risk a good chunk of your capital -- and potential profits -- with these ultra-risky stocks. No one can correctly predict the outcome of clinical trials, after all, and holding on after a sizable move higher has proven time and again to be a mistake with developmental biotechs. Novavax and countless others should serve as ample warning to the greedy. 

Monetize your shares while waiting

Once you've unearthed a hidden gem, waited until it bore fruit, and took profits, you then can employ the third part of this strategy: selling covered call options on your remaining shares. To do so, you'll need a little foresight to ensure that you have enough shares to have them bundled in lots of 100.

If you're not familiar with options trading, you can find a good primer here. But the short story is that each option contract gives a buyer the right to purchase 100 shares at a time -- so you need lots of 100 in order to write a covered call contract. The contract is said to be "covered" because you actually own the shares against which the contract is based. 

What does this part of the strategy accomplish? Assuming you've made it successfully through the first major clinical or regulatory catalyst, the company's shares should be ripe for covered call writing. The underlying idea is that biotechs can take months -- if not years -- to realize their full potential.

During this lengthy waiting period, the company's stock will probably be exceptionally volatile and prone to waves of short-selling. So instead of selling your remaining shares out of frustration, you can use this waiting period to your advantage by generating income via covered calls. 

The basic concept is to choose call options that are no more than three months away from their expiration date, and sell calls that maximize your profit without putting your shares at serious risk of being called away by a sharp rise in price. 

Let's run through an example to clarify the advantages of selling covered calls on clinical-stage biotechs. At the time of this writing, Mirati's stock is trading right around $60 per share. For didactic purposes, let's say you originally owned 2,000 shares. You then sold half when the stock doubled from your original purchase price, leaving you with 1,000 shares today.

At today's prices, you could sell 10 September call contracts for a premium of $225 per contract at a strike price of $70 per share. That move would yield a gross profit of $2,250 for 10 contracts. The risk here is if the stock heats up and shoots past the strike price of $70 by the September expiration date. In that case, your shares would probably be called away when someone exercised the option you sold -- meaning you would lose any upside beyond the $70 strike price. 

Even then, however, you would walk away with a 20.4% profit in less than two month's time (share-price appreciation plus the premium of $2,250 you gained by selling the covered call). More likely than not, though, Mirati's stock will fail to reach $70 per share at the time of expiration, meaning you can pocket the entire $2,250. 

The power of this strategy is twofold: Firstly, you can collect income while waiting for the company's next major catalyst, and secondly, it lowers your downside risk through the accrual of premiums (the money you are paid for writing the contract). 

Summary

Investing in clinical-stage biotechs is attractive because of their potential to generate enormous gains in a short period of time. But these stocks also tend to sport ginormous risk profiles that make them unsuitable for the classic "buy and hold" investing strategy.

Here, I've outlined a three-step alternative to the buy and hold strategy that greatly reduces the risk posed by these stocks. Admittedly, my strategy does result in lower total gains for biotech stocks that rise sharply in price, but it also reduces the very real potential for catastrophic losses when clinical or regulatory setbacks take place.

In fact, I'd argue that this approach offers a viable way to invest in these high-reward, high-risk stocks without losing a big chunk of your initial capital -- at least in most cases.

George Budwell has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.