Biotech Sector Trading Strategy: Overview, Backtest, and Example

Considered a part of the technology sector, biotech stocks represent an important part of the Nasdaq market, and they tend to have big growth potential. But what are biotech stocks?

Biotech is an industry group that includes companies that research and develop drugs, wearable medical gadgets, and other diagnostic technologies for the treatment of diseases and medical conditions. The biotech industry group presents exciting opportunities for investors.

In this post, we take a look at the biotech industry group, and at the end of the article, we present a backtested biotech trading strategy on XBI (the ETF that tracks the biotech sector).

What are biotech stocks?

Biotech stocks are stocks of companies in the biotech industry group, which is considered a part of the technology sector. Stocks in this industry include those of companies that develop drugs and diagnostic technologies for the treatment of diseases and medical conditions. Such products go through rigorous, costly, and time-consuming trials before getting approved by the U.S. Food and Drug Administration (FDA).

While the industry group is dominated by large, well-established corporations that develop a range of drugs and technologies, there are also smaller start-up companies in the industry that are recently gaining traction. Biotech stocks are considered a part of the technology sector, and they represent an important part of the Nasdaq market. The stocks tend to have big growth potential. With the emergence of the Covid-19 pandemic, many biotech companies shifted their focus majorly on Covid-19 vaccines and treatments.

Is biotech a good investment?

Biotech companies develop and market health products, which must be approved by the U.S. Food and Drug Administration before they can be marketed in the US. To get approved, the products usually go through rigorous, costly, and time-consuming trials.

If you are investing in a company with many products in the pipeline, which is often the case with many of them, it may take years before knowing whether a drug under development will be approved and therefore able to make money. As a result, biotech stocks may be good for long-term investment.

Interestingly, many of the best biotech companies have both strong drug candidate pipelines and winning drugs already on the market. Moreover, the COVID-19 pandemic has also created massive opportunities for biotechnology companies that are developing treatments and vaccines for the virus. So, there is no better time to invest in biotech stocks.

Given that their price movement is sometimes quite wild, biotechnology stocks can also be used for short-term trading strategies, as the wild price swings offer good opportunities for traders. The stocks often have big intraday moves, which make them good for day trading. Swing traders and position traders can also enjoy trading biotech stocks, as they often move in strong multi-day and multi-week trends.

How to trade biotech sector or stocks

You can trade individual biotech stocks, especially if you are interested in short-term trading, such as day trading or swing trading.

If you are more interested in long-term investing, it may be better to trade biotech exchange-traded funds (ETFs). Such ETFs invest in a basket of biotech stocks, thereby offering you a ready-made portfolio of biotech stocks. This reduces risk and potentially maximizes profits.

The most liquid ETF for the biotech sector is XBI. It started trading in 2006 and has an average volume of about 5 million shares per day, making it a very good trading vehicle.

Biotech sector performance

The biotech sector is often hailed as the new “promising” sector. However, the performance has been more or less similar to Nasdaq (most biotech companies are listed on Nasdaq):

Biotech sector performance
The biotech sector has performed more or less in line with Nasdaq. Source: FactorResearch.

Biotech sector trading strategy (backtest)

Biotech is a bit of a “forgotten” sector among traders, despite the fact that the sector frequently correlates little with the overall stock market.

Let’s go on to backtest a biotech trading strategy with specific trading rules and settings. Our strategy has the following equity curve (you don’t want a perfectly even curve, one that Characterizes a curve fit strategy):

Biotech trading strategy (backtest)
XBI trading strategy: Our biotech trading strategy has a pretty stable and even sloping equity curve.

There are 178 trades, the average gain per trade is a solid 0.9%, CAGR is 9.5%, the time spent in the market is 13%, and the max drawdown is 17%. All in all, we believe these are solid strategy metrics for a strategy that has two buy variables and one sell variable.

The XBI strategy is available in both plain English and Amibroker among over 100 other strategies and ideas:

You find many more trading ideas on our landing page called best trading strategies.

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Is biotech a good investment?

Biotech can be a good investment for both long-term and short-term strategies. Long-term investors may benefit from strong drug pipelines and winning drugs on the market. The industry’s focus on Covid-19 treatments and vaccines has created additional opportunities. Short-term traders can leverage the sector’s volatility for day trading, swing trading, or position trading, as biotech stocks often exhibit large intraday and multi-day price movements.

How can I trade the biotech sector or stocks?

Trading biotech stocks can be done through individual stock trading for short-term strategies. For long-term investing, consider trading biotech exchange-traded funds (ETFs) like XBI, which offers a diversified portfolio of biotech stocks, reducing risk and potentially maximizing profits. XBI, with its high liquidity, is a popular choice for trading the biotech sector.

What is XBI, and why is it recommended for biotech trading?

XBI is an exchange-traded fund that tracks the biotech sector. It started trading in 2006 and is highly liquid, with an average daily volume of about 5 million shares. It serves as an excellent trading vehicle for investors interested in the biotech sector due to its liquidity and representation of the industry’s performance.

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