If you’ve ever bought a stock or an option tied to the biotech sector, then you’ve likely had one of two experiences — and quite likely you’ve had both. Experience A) the company you bought had a new drug that was granted FDA approval, and the stock and/or option delivered you some huge gains. Experience B) the company you bought had a new drug that was denied FDA approval, and your stock and/or option tanked. That’s the hit or miss nature of the biotech beast, and while this can lead to some big rewards, it can be very risky even for the most intrepid investor.

But ask yourself this — if there was a way to mitigate your individual company risk and still participate in the big upside inherent in the biotech sector, wouldn’t it behoove you to check it out?

In trying to formulate such a strategy, I first took a look at a way to own a basket of biotech stocks that would be largely immune from the huge peaks and valleys you can experience when owning individual biotech stocks and/or options. Naturally, the answer was to own a biotech exchange-traded fund (ETF), and the biggest, most liquid and broadest-based ETF in the sector is the iShares Nasdaq Biotechnology (NASDAQ: IBB). This fund, which seeks to mirror the price and yield performance of the Nasdaq Biotechnology index, was up 14.84% in 2010. The red-hot sector fund also recently hit a multi-year high.

Interestingly, on Monday, Jan. 3, tradeMONSTER reported that volume in the IBB March 90 Put options actually ramped up that day. What this means is there’s some big money betting biotech will be headed back down relatively soon. If you suspect this might be the case, yet you still want to participate in any potential upside in the sector, then you too could buy put options as a hedge while also owning the underlying ETF. If you believe the put buyers are wrong, and that biotech will keep on powering higher, then you can in essence double down on your bullish bet and buy IBB call options.

So, if you want to be a better biotech investor, then get yourself some broad-based exposure to the sector with a purchase of IBB. Then, depending on how you see the sector going, you can use puts to hedge your downside, or calls to give yourself a chance at a hyper-dose of sector upside.

DISCLOSURE:  Jim Woods has no current positions in any of the above mentioned securities.