The Food and Drug Administration (FDA) has a labyrinthine approval process for new drugs. This is good news for consumers, bad news for drug companies and an opportunity for short-term traders. The approval process creates intense price volatility among the publicly traded companies that are involved, particularly those early stage companies with little revenue.

There are several companies with approvals pending before the FDA that a trader can build either long or short positions around to take advantage of this volatility.

Early Stage Biotech
In February 2008, the FDA accepted a review request by Cypress Bioscience (Nasdaq:CYPB) and Forest Laboratories (NYSE:FRX) for a new drug application for Milnacipran, a drug for use in treating fibromyalgia syndrome. Milnacipran was approved for use in Austria but Cypress is attempting to bring it to North America. An approval or rejection decision is expected at the end of October 2008. If approved the drug can legally be marketed and sold. (To begin with the analysis basics, read Measuring The Medicine Makers.)

Cypress Bioscience is an early-stage biotechnology company that had only $15 million in revenue in the first six months of 2008. Almost all of the revenue was payments from Forest Labs in connection with Milnacipran. A negative decision from the FDA might be devastating to the company, although the company did have $153.4 million in cash, cash equivalents and short-term investments as a cushion at the end of the June quarter. Either way, a binary outcome is probable.

Forest Labs is a more diversified company with revenue in its latest fiscal year of $3.8 billion so the upcoming FDA decision on Milnacipran will have less impact on this company. Forest Lab's two main drugs are Lexapro, used to treat depression, which represented 66% of sales, and Namenda, used to treat Alzheimer's disease, which was 24% of sales in fiscal 2008.

Ligand Pharmaceuticals (Nasdaq:LGND) is another early-stage drug company with a new drug application pending before the FDA. Ligand technology was used in the development of Fablyn, which can treat osteoporosis, and was developed in collaboration with Pfizer (NYSE:PFE). An FDA panel gave the chances for approval a boost in early September 2008, when it said the drug might prove more beneficial to patients given the risks. Ligand had only $9.7 million in revenues the first six months of 2008. The company is not solely dependent on Fablyn, as it has collaborations with other large drug companies including Wyeth (NYSE:WYE) and GlaxoSmithKline plc (NYSE:GSK). A decision is expected sometime before the end of 2008 and if approved Ligand will receive royalty payments and cash.

Discovery Laboratories (Nasdaq:DSCO) is seeking approval for a drug called Surfaxin for the prevention of respiratory distress syndrome (RDS) in premature infants. The company only had about $4.5 million in revenue in the first six months of 2008. The FDA issued an approvable letter in May 2008, and Discovery Labs is expected to respond to that letter shortly. If the response is designated a "class 1" resubmission, then a decision is expected from the FDA before the end of the year.

Bottom Line
Volatility is the lifeblood of a trader, and the binary outcome of the FDA new drug application process provides plenty of it.

For more on trading the biotech industry and the drug approval process, read The Ups And Downs Of Biotechnology.