Not long ago, I received a call from an investor relations representative who wanted to know if I’d be interested in hearing about a small biotech company with a drug candidate in Phase 2 trials.

Do Yankees fans want Aaron Judge back in the lineup?

Phase 2 trials are my favorite time to get involved in a biotech company. I’ll explain why in a moment. But first, a quick review of the phases of clinical trials…

The Three Distinct Phases of Clinical Trials

Before a new experimental drug is tried in humans, it’s put to work in test tubes, then animals. Once it’s ready for human trials, it’s tested in three distinct phases.

The Phase 1 trial is conducted with a limited number of subjects, usually fewer than 50. In cancer trials, the drug will be given to patients sometimes as a last resort.

Drugs targeting diseases other than cancer are given to healthy volunteers so doctors can better understand how the drug reacts inside the human body.

If a drug is deemed safe after this period, the company will proceed to Phase 2. This trial usually consists of a few dozen to several hundred patients receiving varying dosage levels of the particular drug.

The data that’s considered most accurate is from a trial that’s “double blind” (neither the patient nor the doctor knows if the patient has received the drug) and placebo-controlled (compared with a placebo or standard of care).

Some, but not most, Phase 2 trials are double blind and placebo-controlled.

In Phase 3, companies test hundreds to thousands of patients. If the data proves that the drug is safe and effective, the company will usually apply for approval.

Naturally, the more patients who take part in a trial, the greater the chance the drug fails. For example, the drug may not work, or there may be unexpected side effects. This is especially common in cancer trials, where the response rates are low, even with approved drugs.

Positive results in Phase 3 can push a stock higher as investors begin focusing on approval and the sales and profits that could follow. However, it doesn’t always work that way.

Many drugs with seemingly strong Phase 3 results have been rejected by the FDA for one reason or another. This can crush investors who followed a drug stock all the way to the end.

Alkermes (Nasdaq: ALKS) is a great example. Investors got their hopes up when Phase 2 data showed that Alkermes’ antidepressant ALKS 5461 was safe and effective for patients who did not respond adequately to standard therapies. Yet the FDA rejected it after Phase 3 results and shares tanked.

This is one reason why Phase 2 is the real sweet spot for biotech investing.

Phase 2 Trials: A Profitable Time to Be Involved in Biotech Stocks

Phase 2 is often the most profitable time to be involved in a small cap biotech stock. Many times, Phase 2 results are positive. Sometimes it’s because the drug works. And other times it’s because the trial is rigged to provide positive results.

For example, Cel-Sci (NYSE: CVM), a company that stirs passion (both positive and negative) among biotech investors, ran a Phase 2 study on the head and neck cancer drug Multikine.

However, instead of being tested against existing treatments, Multikine was given along with an existing treatment.

At the end of the trial, Cel-Sci boasted of a 12% complete response rate. But it was impossible to determine if the two (out of 19) patients who had a complete response saw their tumors disappear due to Multikine or the other treatment.

So why would a company do that?

To show good results in the hopes of raising additional capital.

There are also times when the science is conducted properly and Phase 2 claims are valid, but the drug isn’t able to replicate results in a Phase 3 trial. Remember, a Phase 2 trial usually contains a much smaller sample size, which can easily distort results.

Very often, when a company reports strong Phase 2 results, the stock takes off, as Phase 2 results are the first real indication that the drug might be approvable. Investors get excited, potential partners begin sniffing around and the media begins to cover the drug’s potential.

Even though at this point things are just starting to get promising, it’s often a great time to take the money and run.

Here are a few great examples…

Last year, Dermira (Nasdaq: DERM) released positive Phase 2 results for its drug lebrikizumab – an immunosuppressive used to treat asthma. The stock doubled in value almost immediately.

Novocure (Nasdaq: NVCR) – one of my past recommendations in my biotech trading service Lightning Trend Trader – released strong Phase 2 results last September.

We closed out a 228% gain on my options recommendation in October.

Something similar happened in July 2018. I recommended Regeneron Pharmaceuticals (Nasdaq: REGN) following positive Phase 2 results. Shortly thereafter, we closed out a 108% options gain.

Phase 3, on the other hand, is fraught with risk. These trials are expensive to run, and there’s no guarantee that the drug will again show strong results.

For example, there have been some instances where the drug replicated its earlier results, but there was also a stronger-than-expected response from the placebo group, narrowing the difference that the drug made and making it appear less effective.

Taking Off in Phase 2… and Failing in Phase 3

There are many examples of stocks that have taken off during or after Phase 2 results, helping investors make lots of money. But they then suffered losses when the drug failed in Phase 3.

Here’s a great example…

Several years ago, my subscribers made money on Medivation despite a disastrous Phase 3 trial that resulted in the stock plummeting.

Medivation had a drug for Alzheimer’s called Dimebon. The Phase 2 results were outstanding. They showed that the drug promoted slower mental deterioration and fewer side effects than the existing therapies, including Pfizer‘s (NYSE: PFE) Aricept.

Despite skeptics’ doubts, the stock ran in anticipation of Phase 3 results. If the data was strong and the drug got approved, it would likely be an immediate blockbuster.

After the stock doubled, I recommended that subscribers take half of their profits off the table.

Note, this is not the usual Oxford Club philosophy. But with small cap biotech stocks that can plummet on one piece of news, I often suggest readers take their risk capital off the table once the stock has risen 100% or more.

So with investors now playing with the house’s money after taking their initial investment back, we waited for the Phase 3 results.

As it turns out, the drug didn’t work.

The stock got crushed, and we sold our remaining position. But because we had sold half at a 100% profit, we still pocketed a 37% gain. Not bad for a failed drug…

If the Smart Money Leaves… Take Your Profits and Follow

There have been several instances where something similar has occurred.

I recommended Celldex Therapeutics (Nasdaq: CLDX) right before the company released positive Phase 2 clinical trial data on its treatment for triple-negative breast cancer… and the stock surged 419%.

We also made 102% gains on Delcath Systems (OTC: DCTH) and 42% gains on Mela Sciences (Nasdaq: MELA), despite FDA rejections.

Although in these cases the Phase 3 trials were not deemed a failure, the FDA rejected the applications for approval until more questions were answered.

After positive Phase 2 results, you sometimes see the early investors and venture capitalists exit the position. They’ve made their money and don’t want to stick around for the risky Phase 3.

If the smart money is leaving, it may be a good idea to follow them out the door. At least with part of your investment.

There’s nothing wrong with hanging around and seeing if a small biotech company can get the ball across the goal line and get its drug approved.

But considering that less than half of all drugs in Phase 2 actually make it to the market, it’s a smart idea to take profits along the way when you can.

When a solid company enters Phase 2 trials, I often see it as a powerful buy signal. But this isn’t a buy-and-hold investment… You have to be ready to exit your position quickly and lock in your gains.