When mergers happen, here’s a good way to trade them
Compound your probabilities, even when trading
mergers.
One place that short-term active traders have always been able to make some
money is in trading mergers. Mergers are different from other pair relationships
in that there is a contract that defines what ratios a merger should be traded
at. For most traders the best mergers are those that are stock for stock and do
not contain any adjustments like floating ratios or collars.
Take a look at Procter and Gamble
(
PG |
Quote |
Chart |
News |
PowerRating) merging with Gillette
(
G |
Quote |
Chart |
News |
PowerRating). The merger is
scheduled to close some time between October and December and has a ratio of
0.975 shares of PG for every share of G. This means that on the date of the
merger closing 0.975 shares of PG should be priced equal to 1 share of G, if not
a true arbitrage exists.
Like all pairs, you can trade a merger from both directions. Each trade has a
separate set of risks or benefits to it. If you are short the spread (short PG,
long G), then you should slowly make money until the merger closes. Of course
you do take on the risk that the merger does not close and the premium that was
charged for the target stock disappears. In the case of PG and G, PG offered an
18% premium for G. If the merger does not go through the 18% premium will be
removed from the stock and if you are short the spread (i.e. long G), you would
lose 18% when they announce the merger is not closing.
When trading a spread from the long side you would slowly lose money as the
spread looks to close, but capture the big move if the merger is called off. In
some ways this is like an option with an expected cost and a big pay off if you
are correct.
Now one of the main things trader’s need to look at is what will the payoff be if
the spread does close. Look at the following chart of
(
PG |
Quote |
Chart |
News |
PowerRating) and
(
G |
Quote |
Chart |
News |
PowerRating):
The spread price is currently $0.52. This means that if you short 0.975 shares
of PG and went long 1 share of G you can expect to make $0.45 between now and
the close of the merger. If you look at yesterdays closing stock price of $56.69
for PG and $54.75 for G this represents a yield of 0.47% ($0.52/($56.69+$54.75))
between now and the close of the merger.
This brings us to the one of the difficulties when trading mergers: when will
the merger close? In this case we are looking at some time between October and
December, so lets assume it is mid November (November 15 to be exact). This
means that this yield of 0.47% occurs in 53 days, so the annual yield is 3.23%.
Now this might not seem like much, but with today’s low interest rates and the
ability for hedge funds to leverage this it makes for a significant return.
Consider a firm that could leverage 6 times their capital as long as they are
hedged: this return now represents a 19.38% return on the underlying capital.
These are figures that are much more exciting.
As a professional trader I won’t look to be holding the spread from now until the
close, I will just use this calculation and the fact that the merger has been
around for a long time and cleared most regulatory hurtles to create a bias of
trading the spread from the short side. I would try not to hold the position
overnight so that I would limit the probability of me being in the spread if it
blows up. The predictability of mergers is what is attractive, so I would be in
and out frequently to capture as many rolls as possible.
Notice how in this case the actually price of the stocks is irrelevant, the
contractual relationship between the stocks dominates over any support or
resistance numbers.
It is actually possible to calculate the risk of a blow up occurring and the
probability of the spread blowing up, but these are stories for different days.
From here the important thing to notice is how you can capture the predictable
ins and outs to make a lot of smaller trades for consistent profits.
For more information visit our website at
www.pairtrader.com
Darren Clifford
Darren Clifford is a professional equities
trader with Bright Trading. Mr. Clifford has recently been ranked one of the top
30 traders under 30 by Trader Monthly magazine.
Mr. Clifford holds a masters degree in Economics from Simon Fraser University
specializing in Financial Mathematical Modeling. He is also the president of
www.pairtrader.com, company dedicated to
providing the tools and data necessary for hedged equity trading.