It's understandably very tempting for people with inside information to trade biotech stocks. With the potential for overnight doubles and triples after binary events, there's quick money to be made.
They shouldn't. It's illegal. But that doesn't stop them.
Some even get caught. These are their stories. There's a lesson -- beyond that you could go to jail -- in their actions.
Baking cupcakes in jail
Perhaps the most famous insider trading involves Martha Stewart who was sentenced to five months in the pen for selling shares in ImClone Systems, allegedly on a tip from her stock broker who figured out that ImClone's CEO Sameul Waksal and his daughter had sold shares right before the Food and Drug Administration decided not to accept ImClone's application to market Erbitux.
She avoided a loss of $45,673 by selling her shares prior to the 16% drop after the FDA's decision was announced publicly. Hope the inmates enjoyed the cupcakes.
How to avoid insider trading
I'd start by not doing Internet searches on insider trading detection and reading articles titled "Ways to Avoid Insider Trading" -- unlike Robert Ramnarine, who reportedly did just that. The executive at Bristol-Myers Squibb (NYSE:BMY) has admitted to using his inside knowledge of Bristol-Myers' potential takeover targets to buy options in the companies, including Amylin Pharmaceuticals, prior to the announcement of the acquisitions.
Really on the inside
It's not too hard to figure out whether drugs will be approved if, like Cheng Yi Liang, you work at the FDA. Liang reportedly racked up $3.6 million in profits from his inside knowledge.
In some cases, he played both sides of the bet, like for Momenta Pharmaceuticals (NASDAQ:MNTA) when he shorted the company before the FDA delayed approval of Momenta's generic version of Sanofi's (NYSE:SNY) Lovenox in 2007 and then went long when the drug was finally approved in 2010.
The big profits came when most investors weren't expecting approvals. Liang's biggest gain came from approval of Vanda Pharmaceuticals' (NASDAQ:VNDA) Fanapt after the surprise approval. No one saw that one coming.
And the list goes on
Last year, the SEC charged a bunch of high school friends who worked at Celgene (NASDAQ:CELG), Sanofi, and Stryker (NYSE:SYK) who reportedly shared non-public information about earnings announcements, regulatory decisions, and takeover targets, including Sanofi's takeout of Chattem for a 34% premium.
The government also charged a hedge fund manager for selling shares of Elan (UNKNOWN:UNKNOWN) who got tipped off to the failure of the company's Alzheimer's drug bapineuzumab by a member of the Safety Monitoring Committee in charge of the clinical trial.
You don't have inside information, but...
The attraction to the biotech industry for criminals is the same reason it appeals to lawful investors. The binary events provide for substantial upside. Just keep in mind that, unlike those with inside knowledge, you're also exposed to the downside. Keep your purchases and shorts to a reasonably small percentage of your portfolio.
Fool contributor Brian Orelli has no position in any stocks mentioned. The Motley Fool recommends Celgene and Momenta Pharmaceuticals. The Motley Fool owns shares of Momenta Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.