There’s a hidden danger in biotech stocks few investors can see right now.

The danger is very real and will cause a lot investors to miss out on one of the best investment opportunities you can find the next few years.

But if you identify this danger now and learn specifically how to protect yourself from it, the biotech bull market could provide you with serious gains in the next couple of years.

Here’s what you need to know now and what to do about it.

A Bubble is Born

Given the boom-bust nature of the biotech sector, a bull market in biotech stocks is something no investor can afford to miss.

Two years ago it was clear biotech stocks were in a bull market.

Between March 2009 and July 2013 The Nasdaq Biotechnology Index rose 202%. Biotech handily beat the the S&P 500 return of 123% over the same time period.

 

That kind of above-market performance is exactly what starts the positive feedback loop which turns a bull market into a bubble.

Since then that’s exactly what’s been happening. The S&P 500 added another 24% while the biotech soared 101%.

After a run like that, potential biotech investors are put in very a tight spot. Biotech stocks continue to rise and represent a great opportunity. But the risks are now greater than ever.

Here’s a perfect example of the rising risks and the simple way to avoid them to show what I mean.

This week biotech investors saw how great the risks in biotech are at this point in the cycle.

The story is one we’ve watched play out a lot in the biotech market. But it was far more severe than usual.

The situation I’m talking about concerns XOMA Corp (XOMA).

XOMA is a classic biotech story. Years of development and millions of dollars in development all riding on the success or failure of the drug’s efficacy and safety in clinical trials.

All the analysts covering it loved it. All six of them had “Buy” or “Strong Buy” ratings on it.

Of course, biotech stocks like XOMA which have been built mainly on one drug in development truly live or die on these results.

Earlier this week XOMA died.

The clinical results were for its gevokizumab drug were released and they were not good.

The drug, which treats patients with Behcet’s disease uveitis which affects about 280,000 people in the U.S. each year and millions more around the world, did not show strong enough efficacy within the allotted time of the study.

The results didn’t say the treatment didn’t work. They just said it didn’t work in the length of the study.

XOMA’s shares, which surged the week before to more than $4 following a very bullish forecast from an analyst, plummeted after the news came out.

They dropped to less than $1 per share for a one-day drop of 75% and two of the six analysts covering the stock put “Sell” ratings on it.

Granted, moves like this happen in biotech all the time.

But the difference at this point in the biotech bull market that bad news is not usually taken this severely by the market.

That’s where the bigger point comes in about the dangers in biotech stocks right now.

Simply put, the risks in biotech are more extreme than they’ve ever been.

The problem is caused by the bull market in biotech market itself.

After running up more than 500% in the last six years, the risk/reward mix has shifted completely against investors.

That’s not to say that biotech stocks aren’t going higher or there’s no opportunity left in biotech stocks. There certainly is opportunity. Huge opportunity.

It’s just to say all investors who are getting into biotech now have to do so differently.

The Only Way to Buy Biotech Today

The best way (and probably only safe way) to buy into the biotech boom at this point is to buy the cheapest biotech stocks in the market.

This is not an opinion. I’ve got stats to back it up.

I can’t tell you the stocks in my Top 5 Stocks to Ride the Biotech Bull report, but I can tell you about some of their returns.

Over the last five years these five stocks are down an average of 70% each.

That would seem like a disaster.

It’s not a disaster though. Precisely the opposite.

In the first half of this year those stocks rose an average of 36% each. That’s almost double the 19% for the Nasdaq Biotechnology Index over the same time period and more than quadruple the the S&P 500.

The reason for the performance is because they were bought cheaply, after a sharp drop in price and when the potential rewards far outweighed the risks.

Basically, at this point in the biotech bull market, if you want to win and win big, you have to buy the ultra-cheap biotech stocks which have hit some stumbling blocks.

Most biotech stocks are priced for perfection. Any slip-up has huge and costly consequences. The cheap ones which are already down big offer the far biggest rewards for the least risk.

Over time, if you ensure the potential rewards outweighs the risks, you will do very well as an investors whether in biotech stocks, real estate, or anything else.

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