Risk Arbitrage is identifying a deal of merger and aquisition that has been announced but has not gone through officially yet and in an all cash offer, buying the company to be acquired, and in an all stock deal buying the to be acquired company and selling the company doing the acquiring.
Risk Arbitrage with options is instead using calls and/or puts to accomplish the same thing, but with unique leveraged instruments.
In the early days, Warren Buffett used to participate in these until he met Charlie Munger and Munger convinced him of sticking with other methods.
Long Call Options and Risk Arbitrage
A call option gives the call owner the right to buy 100 shares of a stock (per contract) at a particular agreed upon price (the "strike price" is the term to define the agreed upon price). It forces the seller of the call option to sell the stock itself at that price should the call owner decide to "execute" your option rather than just sell it to someone else.
For example, if a stock is priced at $90 and there is a deal announced for $100 per share, you may decide to buy call options with a strike price of $95 and make the difference between the price at the close of the deal and this strike price (in this case $5 per share), and the cost of the option. If you can buy the option for $1.70 per share (or $170 per contract) and the deal goes through, you can sell the option for $5 and make $3.30 per share (or $330 per contract) if the deal of the stock closes at $100. However, if the deal fails, you'll likely lose 100% of what you risk. In fact, even if the deal is delayed and the stock goes up from $90 to $96.69 or less you will lose money, and if it doesn't go at least to $95.01 you will still lose all of it. With options you have to be right on timing, price, AND for out of the money options you need to be right on the magnitude of the move. This example allows a return of almost 3 times the risk, which means you can lose 3 times and nearly break even on the 4th. So to make money the deal has to go through more than 25.4% of the time. We actually should only plan to make this trade if the odds are much higher (like 35%) because of volatility, risk, and to pay for missed opportunity.
One variable I haven't mentioned yet is time. Eventually options expire and when they expire you either sell them, exercise them, or they expire worthless. Unless they are trading above the strike price for call options, (and sometimes if you sell them before the end of the day on the final trading minute of the final trading day before options expiry) they will almost always expire worthless because no one else will want to buy the, knowing they will soon be worthless. The tricky thing about arbitrage deals is they can take longer than you initially expect.
One of the tricks of options is position sizing. Normally when you buy a stock you might put 10% in a stock and if it drops 10% you might sell. This is a 1% loss to your portfolio. But if you risk 10% on an option you have a 10% loss to your portfolio. Lose multiple times and you will have a hard time making it back. A 20% loss requires a 25% gain, a 50% loss requires a 100% gain. While options do allow leverage, making back those gains eventually It doesn't take too many losses for the position size to hurt you even with an edge. However, if you risk 1% per option, you only incur a 1% loss if you are wrong and you can lose 10 of those and be down 10% and only need an 11% portfolio gain to get back to even. The thing to realize about options is the problem is time PLUS price.
Options can work well for risk arbitrage plays because there usually is a clearly defined time frame and a clearly defined buy out price, so you can calculate your exact upside if the deal goes through, and your downside can be 100% as opposed to worrying about a stock that could easily gap down substantially before you could sell the stock itself.
So with this basic understanding we can look at other strategies for merger arbitrage plays.
Covered Calls And Risk Arbitrage
Rather than just buying call options on an all cash deal for risk arbitrage, you may attempt covered calls. Covered calls is where you buy the underlying stock and sell a call at a strike price against it.
For example, awhile ago RAD was selling at $5.60 with a deal that would either be $6.50 or $7.00. The FTC denied the initial deal at $9 for the entire company but after revising the deal downward and offering to divest from a certain number of stores to satisfy the FTC it could go through again at either price depending on how many stores required to divest from. The deal was expected to go through at the end of July.
The call options with expiration date of the 3rd week in July with a strike price of $6 were trading at $0.45 (per share or $45 per contract of 100 shares). That means that if you buy the option AND the deal goes through for $6.50, you'll only make 5cents and you're risking 45 cents per share if it doesn't. That means the deal has to go through 90% of the time to break even as a call buyer. Even if it goes through for $7. That's still $1 made on $.45 risked which is a little higher than I'd prefer. Also, I'd usually want to buy a couple months past when the deal is said to go through because it may get delayed again, this actually doesn't even finish out the month of July which means there's a good chance we can lose even if the deal goes through. If it's a bad situation for the call buyer, you should think about being the call seller.
Selling calls without owning the stock is dangerous. Although this would be the best possible situation a call seller who doesn't own the stock could be in with a likely capped upside, there is still a rare possibility of another bidder coming in (RAD would have probably already looked at all possible bidders and someone else would have probably come in by now), or something weird like the deal failing but the shares going up beyond $7. Plus, I think the deal still probably goes through more than 50% of the time so we want to own some of the exposure.
This is a perfect situation in my view for a covered call.
In other words, we buy the stock and for every 100 shares that we buy, we sell a July option with a $6 strike price. In the most likely situation given a buyout goes through before expiration, we keep $0.45 per share that we collected from the premium, we keep $1 that we make from the stock from $5 to $6, and we give up our stock at $6 per share and forfeit any additional gains, should they occur. In other words, when we are right, we make $1.45 per share. If the deal fails, we still collect $0.45, but we have to hang onto the stock until the option expires, unless we want to close on the option first and then sell the stock afterwards (but there's usually extra transaction fees for this).
The options are like a $0.45 insurance policy in exchange for giving up the gains beyond $6. It insures $0.45 of damages should the stock decline, but we'll still have to take the loss of the difference.
If we expect this deal to go through 2/3rds of the time, we'll make $1.45 each time or $2.90 for the two times, and on the 3rd we'll make $.45 more for the options or $3.35 for all 3 times including the one that failed. So when it fails the stock will have to drop less than $3.35 to make money (not including fees, transactions, and weird situations like a revision of the takeover price or early execution that can mess with the expectations) Since the price is $5.66, that means it would have to fall to $2.31 or lower when we're wrong to lose money (or we'd have to overestimated the chances that it goes through).
I don't know exactly what will happen if the deal fails, but it seems reasonable enough that this trade is profitable. Some people will look at the price a stock was trading at before it announced the deal and use that as the expected loss. I think the actual probability might be higher. Also, I think I'll probably collect the premium in July and that will possibly allow me to collect an extra $.50 to $1 when the deal goes through, or possibly sell August options, or if it's trading close to $6 I may even exit early rather than risk the possible deal failure.
Long Stock And Risk Arbitrage
There are plenty of situations which you would not wish to buy the option but would wish to own the stock without selling covered calls. One example is when the calls have such a wide spread between the bid and ask that you can't buy or sell them at any reasonable price. This happens more often than you might think. But if this happens, you still may wish to consider risk arbitrage if the deal seems good enough. You also may wish to do this if the stock is trading at $1 and the deal will go through at $2.50 or less and the only options available are $2.50 and they are only available for buying at $0.05 and sellers are unlikely to collect. In other words, if the strike price of the option doesn't make sense for either side. Not all stocks trade options so that's another reason you may not wish to play options.
The way options are priced usually make deals that have higher net profit better than shorter time frame. However, if you can get a deal that is expected to clsoe next week for only a 3% gain, and the loss is less than say a 9% loss if it fails, and you can make lots of these trades over a year, that can add up. This is a good reason to make long stock risk arbitrage.
When selecting risk arbitrage, you have to realize that the highest
percentage profit probably have the lowest chance of going through or will be delayed
The Baseline Odds of Risk Arbitrage Deals
According to
insidearbitrage, last year saw 225 deals closed. It also saw 20 deals that failed. It also saw 88 pending deals, some of which were probably delayed and may not close yet, and some of which may have been carry overs from 2015 that still haven't closed. We also don't know how many deals closed at a lower total than initially expected that could have resulted in a loss in options price, a much lower gain in the stock, and possibly even a loss overall in the deal (depending on where you bought). So let's just assume all pending deals are bad deals. We'll say 225/333 closed which is just over 2/3rds. I think this is a good number to use when planning a deal but with higher percentage deals you should expect lower probability of it going through.
I think using the pre-announcement price is a good price to plan on the stock going to if the deal fails.
How Much To Risk?
How much you should risk on these deals and on merger and arbitrage depends on your edge and instrument in general, but when Warren Buffett used arbitrage, he only used it as part of his portfolio. He would take a controlling interest in some and he would just find undervalued situations in others.
One of the benefits of risk arbitrage is the low correlation to the market. The expectation of gain is not very high, but it also will tend to outperform in bear markets because of the low correlation to the market. Buffett would at times use margin to buy risk arbitrage names due to the high probability nature, and his measurable downside and measurable edge, but he would carefully weight the downside, and this was a time when risk arbitrage was not popular, and thus the opportunities were much better. He also was convinced that these were not the best way to play the market over time.
I like it due to the ability to outperform on the way down which can allow capital to buy if things go wrong. Buffett now almost always has some (usually large like 20%) percentage of capital in cash, buys insurance companies which have access to their float and now has access to the federal funds rate to borrow at lower interest than most, plus he has such a good reputation that he is unlikely to see a lot of capital leave his company just because the market sells off and he can also raise money by selling bonds. He also collects earnings directly from companies he owns privately that are relatively immune to the economy. Because of this, he doesn't have a shortage of means to buy when everyone else is selling and raise more capital should stocks sell off.
However, for the average Joe experienced investor, this may be a good option if you do so intelligently. There's a book by Mary Buffett explaining how Warren did these deals if you want to learn more.
