Volume transactions by “institutions” managing multi-billion-dollar portfolios force equity markets into two behaviors: (1) Small regularly-repeatable transactions between individual investors which are system-automated at near-zero cost of handling and (2) giant-volume irregular transactions typically initiated by one institution but (partly) satisfied by groups of other institutions, negotiated by market-making [MM] firms.
The unsatisfied remainder of each giant trade order is only completed when a satisfactory hedge deal in derivative securities can be reached to protect MM capital put at risk of price change to “fill” the supply and demand imbalance created by the initiating institution’s trade order.
The cost and structure of that protection tells what well-informed, experienced investing professionals (on both sides of that trade) think is likely enough to happen to prices (in both directions) to the underlying trade subject’s price to require (and be worth) protection.
Those expectations are highly comparable between any equity securities and are the subject of all actively-traded stocks and ETFs today.
How credible those expectations have proven to be is revealed by well-retained market records, and provides qualitative measures between current-day investment alternatives. Our analysis uses historic comparisons of the credibility and likelihood of current investment choice outcomes.
Risk~Reward Comparison of select Biotech Stocks
This map locates securities at the intersection of prospective price gains (green horizontal scale) and potential price drawdowns (red vertical scale) based on market-maker hedging behavior to protect their necessary endangerment of firm capital as they facilitate volume trades. Desirable conditions are down and to the right.
Figure 1’s location  of S&P500 Trust ETF (SPY) makes clear the nature of what development stage “investments” are being considered here. Of interest are PTCT at  and EDIT at  in the midst of the wide-ranging cloud of alternatives. None are to be confused with the likes of the new-to-be-included Dow Jones biotech stock AMGN – not present here.
In an effective market, Risk is the price of Reward. The question remains as to how to measure risk. Recent decades of academic exploration have made it clear to many that statistical uncertainty containing both positive and negative outcomes is not “a proxy for risk”.
The derivatives markets provide a means of separating risk and reward and of quantifying both in measures proven to be useful. Examples are present in Figure 2.
The rewards and risks of Figure 1 are in Figure 2 columns of [E] and [F]. Top-row PCTC’s +18.9% upside prospect from [D] $48 to [B] $57 compares with EDIT’s upside potential of +23.8%. The risk exposures data of [F] draw from prior experiences rather than from current forecasts. Indeed, market circumstances often make current price risk forecasts an underestimation of what may ultimately occur. They may be more beneficial to the sellers of insurance than to the buyers.
[F] data could come from those prior forecasts (of the past 5 years) where the balance of upside-to-downside price extremes were like what is seen today in [G] of Figure 2.
But instead, the [F] data is an average of the actual worst instances of interim price drawdown below the position’s entry cost in each of the prior [L] forecasts like [G] during the [J] days the position was held. It measures the true price risks actually encountered during the periods of the relevant forecasts, not just of some prior all-inclusive calendar historic period extreme.
The “proof” of the coming price “pudding” is suggested by what proportion of those [L] forecast outcomes wound up at a profit – shown as a % of 100 in [H]. This important dimension is used to weight the actual [ I ] payoffs realized as a ranking figure of merit (fom) when teamed up with a similar offset of [F] weighted by the complement of [H], or 100-H. That action takes place in [O] and [P] when combined in [Q].
PCTC’s odds-weighted net [Q] of 6.2% is a reduction of its [K] CAGR of +86%. As does EDIT’s odds-weighted -5.1% eliminate its CAGR of 35% because its less-than 6% realized payoff is inadequate to offset a drawdown potential of -17.5. Such is the nature of biotech development investing.
While [Q] suggests a sense of scale, its calibration by the TIME required in [J] converts the scale into speed in [R]. The speed is stated in conventional financial-industry terms of “basis points per day” or bp/d. A basis point is 1/100ths of a percent, and in a calendar year of 365 days 19 bp/d sustained for a year doubles the capital invested. On the 252-day market year it takes 27.5 bp/md.
Figure 2’s column [R] provides an inclusive “figure of merit” (fom) useful for preference-ranking of securities where capital-building is of importance in future expectations. The foms show how different are the prospects for PCTC and EDIT, compared to SPY, the SPDR S&P500 Index TRUST ETF (SPY) as a market-proxy.
When price-range forecasts from qualified appraisers are available on a large population of equity securities, as they are in our population of ~2800 MM forecasts, a further notion of opportunity norms is available. Many past-history “norms” of indexes like SPY exist, but very few like this population.
The fom’s principal limitation is that its forecast horizon is limited to the legal lives of the derivative contracts used to imply the range of coming prices. That horizon typically is limited to a few months. The TERMD risk-management discipline referred to earlier sets a time-investment cut-off at 3 months.
The figure of merit ranking has a multi-year daily history of capital-gain (and loss) outcomes for the best odds-on outlooks in the MM forecast population. The bottom blue-row of Figure 2 provides a top20 securities contrast with the row-above forecast population.
The top20 now shows an upside price-change prospect of some +15% gain potential, less than the population’s +18%. But its price-change risk outlook of only -7.5% is much less than the population’s -11% price drawdown average. The payoff appears in [ I ] where gains of +14% have been achieved from top20 prior forecasts, compared to the populations’ mere +3.1%.
Those higher-risk experiences are the culprit. Only 6 out of every 10 population forecasts have been [H] winners (profitable under TERMD discipline) compared to 7 out of every 8 of the top20’s. Time investments also “contribute” to the population’s worst losses, turning an overall average gain into a fom net loss, one worse than had by SPY.
The top20’s smaller time investment of 35-day holding periods boosts its bp/d fom score to better than 30, well above either PTCT or EDIT. Compounding time-investment efficiency with realized payoffs is very powerful, producing triple-digit CAGRS quite frequently.
Editas Medicine (EDIT), like many biotech stocks, is subject to occasional changes in price expectations. Now is not a competitive time for it, but a more favorable one may develop later on. Instead, PCT Therapeutics, Inc. (PTCT) stock is a timely near-term capital-gain prospect among early-development biotechs. Other even better odds of larger likely gains exist in the broader population of stocks.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PTCT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Additional disclosure: Disclaimer: Peter Way and generations of the Way Family are long-term providers of perspective information, earlier helping professional investors and now individual investors, discriminate between wealth-building opportunities in individual stocks and ETFs. We do not manage money for others outside of the family but do provide pro bono consulting for a limited number of not-for-profit organizations.We firmly believe investors need to maintain skin in their game by actively initiating commitment choices of capital and time investments in their personal portfolios. So, our information presents for D-I-Y investor guidance what the arguably best-informed professional investors are thinking. Their insights, revealed through their own self-protective hedging actions, tell what they believe is most likely to happen to the prices of specific issues in coming weeks and months. Evidences of how such prior forecasts have worked out are routinely provided in the SA blog of my name. First months of 2020 to date have produced over 2400 profitable position closeouts in a 76%/24% win-loss ratio.