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.
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.