Risk Arbitrage Strategy
This is one the secret strategies of big investors like Warren Buffett and Carl Icahn. In fact, any investors that is not using stock arbitrage at some level is leaving easy money on the table. There’s no better influencer than a billionaire who does something successfully. An arbitrage trade arises when one company announces that it will acquire another. And, this involves a premium.
The actual operation of risk arbitrage is a style of portfolio management is that you will be buying stocks based on corporate activity (e.g. mergers, acquisitions, spinoffs) in order to capture short-term gains.
Over a 10 year period, the stock market is likely to produce at least 2 or 3 years of losses. In those years, no matter how diligent you are in following the High Yield Investing system, the stocks you own will generally move down with the market. However, by trading on the back of corporate actions, an investor can lock in a specific rate of return and insulate their portfolio from draw downs.
Let’s say that you buy the highest quality stocks at the best prices possible and hold them for years. At some point in that holding cycle, they are bound to suffer a 50% or more decrease in price. That is something you should expect as a rule.
During that same year (or, any year for that matter), there are normally 50 or more corporate mergers happening. It’s the nature of the game. In a merger, one company agrees to buy another, generally for a significant premium. Here’s the best part: typically, the buy price is not reached until the day of closing, leaving a spread.
#1 — Only trade stocks in companies that have already announced a merger deal.
#2 — Stick to all cash deals in stocks with trading volumes above 50,000 if possible.
#3 — Only buy when the rate of return is over 15% annualized.
One way to ensure you always outpace the market by building a cash only portfolio and then executing risk arbitrage trades borrowing against your cash only portfolio. If you want to trade a $10 stock that is being acquired for $12 in three months and you pay a 6% interest rate annually to borrow money in your brokerage account, here’s what the breakdown would be.
XYZ Inc. is being acquired by ABC. ABC is paying $12.00. XYZ has a price of $10.00. The deal is closing in 3 months and you will pay 1.5% interest on the trade. Once the deal closes, you will earn $2.00 on every share you owned.
Sample Merger Trade:
Market Price: $10
Closing Price: $12
Closing Date: 3mo.
Margin Rate: 1.5%
Annual ROI: 74%
In real life, on 1,000 shares, you would pay $150 to borrow the money on margin in order to trade the stock. As long as the deal closed you would earn $2,000 minus the money you borrowed less any trading fees. That’s 18% profit off the trade or 74% annualized.
Mergers can always go bad, and in some cases they do. However, while cash positions in long-term holdings are much better when they are confined to less than 30 stocks, in arbitrage, the more the merrier… as long as you adhere to the arbitrage policy.