Hedge funds and institutional trading desks make huge bets on mergers and acquisitions, much like the pending $69 billion proposed buyout of Aetna Inc. (NYSE: AET) by CVS Health Corp. (NYSE: CVS).
It's not rocket science.
In fact, merger arbitrage, as the strategy is sometimes called, is easy and can be very profitable.
We just notched a gain of 455% in two days, taking off half of one of the positions we put on to play the proposed CVS-Aetna merger in my Zenith Trading Circle.
The other half of that trade could still yield us 2,600%.
Here's how we did it, and how you can, too...
First, We Saw the Opportunity
Merger arbitrage is a trading strategy employed when one company announces its intention to buy another company.
Typically, traders position themselves by buying shares of the takeover target company and selling short shares of the acquiring company.
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That is, by definition, a form of arbitrage. It's betting on the direction of different securities based on a relationship between them.
In the case of risk arbitrage (another name), the relationship between an acquirer and its takeover target assumes the share price of the takeover will rise to, or above, the announced price the acquirer is offering. Shares could trade above the originally announced bid if the takeover target's resistance prompts the buyer to offer to pay more for the company, or if another suitor comes along with a higher offer.
Generally, shares of the acquiring company are sold short in anticipation of that company taking on more debt, overhead, and expenses to buy its target.
The risk in the strategy is that the deal may not be consummated and the target's share price falls back to where it was before the deal was announced. And if there's no deal, the acquirer's stock that has been shorted might rise again since it wouldn't be taking on any additional leverage and encumbering its balance sheet.
While there are other risks, including regulatory hurdles facing prospective tie-ups, the strategy is straightforward. It can be modified simply depending on the strategist's understanding of the companies pre- and post-merger.
CVS wants to buy Aetna.
When CVS announced it wanted to acquire Aetna, which Aetna agreed to for a price of $69 billion, I looked at the deal. The prospects for it going through and the two companies' stock prices showed me an opportunity, and I devised a modified risk arbitrage strategy.
First, I saw that Aetna's shares weren't trading anywhere near the $207 per share price CVS was offering to pay ($145 in cash and .8378 of a share of CVS, which at the time was worth at least $62).
Aetna's shares were trading at $78 when I first looked for a trade, so there was a lot of potential upside in buying them.
Aetna's shares weren't trading anywhere near the buyout price of $207 mainly because the Justice Department was suing to prevent AT&T's proposed takeover of Time Warner, which led investors to believe the FTC and Justice Department would similarly push back on CVS buying Aetna.
Meanwhile, CVS's stock, which had taken an ugly hit in October, traded up on the news.
After digging into CVS's debt, cash flow, and other metrics, like the payout ratio on its 2.75% dividend yield, I determined it was a good buy if it fell back to where it was trading before the announcement. But now that it was in the spotlight, other investors might see its value and buy it whether a deal would be consummated or not.
If the deal fell apart and CVS had been shorted by traditional risk arbitrageurs, it would likely move higher on short-covering and not having to incur more debt.
So here's what we did.
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How We Found 455% Gains Overnight
First, I recommended my members buy some call options on CVS.
Our reasoning was twofold. If the deal fell through, CVS shares could rally. If the deal succeeded, the combined companies could reshape healthcare dynamics in the United States, potentially generating significant earnings. The CVS February $77.50 calls I recommended are up around 20% so far.
But our really big play came on the Aetna side of the deal.
Based on our belief that the merger wouldn't meet the same fate as the AT&T and Time Warner deal because this vertical merger in the healthcare space potentially lowers costs and insurance premiums, which regulators would have a hard time voting down, we wanted to position ourselves for a big pop in AET shares.
We didn't want too much outright exposure if the deal had problems or if it took too long. So, I recommended that Zenith Trading Circle members buy the April $195 calls on AET (hoping it would trade closer to the $207 proposed buyout price) and simultaneously sell April $200 calls.
We bought this vertical call spread for only $0.18.
By putting on a vertical spread for only $0.18, which is our total exposure on this end of our arb position, we could potentially make $5.00 if AET trades at or above $200 before the expiration of our options.
While we're still holding our CVS calls, we took the opportunity to sell half of our Aetna call spread Tuesday when it traded up to one dollar.
Buying the AET $195-$200 vertical spread for $0.18 and selling it two days later for $1.00 had the potential to yield my Zenith members a 455% peak gain on half our position.
While the rest of the spread could trade back down and expire worthless, it could just as easily trade up to $5.00.
We're already winners here, no matter which way the deal goes.
And we've got tremendous potential still ahead of us.
While we tend to target dying companies in Zenith Trading Circle, I am never going to withhold a moneymaking opportunity with this kind of potential from my members. If that sounds like something you could get on board with, don't wait any longer. No one can afford to miss out on a chance at these profits.
You can take down extraordinary gains when you understand how Wall Street really works. Shah's been on the inside, and in his free, twice-weekly Wall Street Insights & Indictments, he reveals how to trade the bigger picture for maximum returns. To get his insight and start beating the Street, just click here.
The post How We Turned Breaking News into 455% Overnight Gains appeared first on Wall Street Insights & Indictments.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.