Mergers present trade opportunities when there is stock changing hands in the deal. The difference between the deal price and the stock price is a measure of risk in the merger moving to completion.
In this article, we’ll walk you through options trades, tied to merger acquisitions, that follow a formula that works. We will also provide a video case-study so you can see the options trade from start to finish.
What is Merger Arbitrage?
Before we begin, let’s define what a merger arbitrage is. A merger arbitrage is a strategy employed by hedge fund managers to make what could be considered “riskless” profits. The process involves buying and selling stocks of two merging companies, taking advantage of the lower stock price due to the uncertainty that comes with mergers or acquisitions. With an eye on probability, savvy investors can purchase before these deals are finalized in order to make some money when they eventually do close!
Options Strategies Surrounding a Merger Announcement
Case Study: Ritchie Bros. Buys IAA, a Digital Vehicle MarketplaceIAA’s press release:
“November 7, 2022 – Ritchie Bros. Auctioneers (NYSE: RBA) and IAA, Inc. (NYSE: IAA), today announced that they have entered into a definitive agreement under which Ritchie Bros. will acquire IAA in a stock and cash transaction valued at approximately $7.3 billion including the assumption of $1.0 billion of net debt. The transaction has the unanimous support of both boards of directors.”
This deal might have the support of the board, but after the deal was announced the stock in RBA sold off over 10%. The shareholders do not like the deal and that is evident through the price of the underlying stock.
More often than not, trade opportunities exist when there is stock changing hands during a merger. This was certainly the case for RBA. After the November 7th announcement, the stock price continued to fall. The acquirer does not have an obligation to increase its bid, but RBA chose to do so after seeing the stock trading lower.
On January 23, 2023, Ritchie Bros. and IAA announced that their merger agreement had been amended to increase cash considerations for IAA shareholders while increasing value for Richie Bros. shareholders.
Ann Fandozzi, CEO of Ritchie Bros., commented:
“We are pleased to have reached an amended agreement with IAA, which reflects feedback we've received from shareholders regarding the best structure for the transaction. We believe that the transaction with IAA will allow us to unlock significantly more value for shareholders than either company could deliver standalone through the realization of cost synergies and additional revenue opportunities.”
The merger arbitrage options trade highlighted in the Masters in Trading video takes advantage of the uncertainty in the merger between Ritchie Bros. Auctioneers (NYSE: RBA) and IAA, Inc. (NYSE: IAA).
A Deeper Look at Unusual Options Activity
After the merger announcement in IAA, we ran a comprehensive real-time scan using Cheddar Flow’s Unusual Options Activity Scanner and noticed 5000 puts traded in the March expiration.
As a market maker, I often witness unusual option activity indicating that someone had access to information beyond what the rest of the street knew. This was especially evident when analyzing large trades prior to merger deals – 5,000 contracts in this case! Such situations presented potential opportunities for outsized returns if done correctly, as identifying undervalued risk is crucial in capitalizing on these events.
In mergers that are done with cash, the underlying stock being acquired should trade up to the deal price quickly. If there is a spread between the deal price and the stock price of the acquired company, the stock market is pricing risk into the deal.
Trading mergers is a sophisticated approach and we suggest paper trading any of the options trading strategies we teach before you risk real money.
This merger arbitrage trade was shared on February 27, 2023. After seeing the 5,000 puts trade in the March expiration cycle with Cheddar Flow's Unusual Options Activity Scanner, it was clear that more uncertainty was coming into the options. The unusual options activity was the telltale sign that a big move was ahead.
To further illustrate this successful trade, you can watch our video demonstration to learn how to use merger arbitrage for even greater returns.
Our Approach at Masters in Trading Community
Every Sunday, we share our Sunday Option Trade Plan, which consists of three options trades, with our Masters in Trading Community members. The trades are shared by Jonathan Rose, founder of Masters in Trading, and Stacy Brovitz, CFA, a veteran trader. We share trades in stock options that present a fixed amount of risk, with the potential for unlimited upside returns.
Every Friday, Masters in Trading Community members get their 4th trade, the REDLINE Trade-of-the-Week. REDLINE trades are seeing an influx of volume and open interest when compared relative to a stocks float. These trades have been big movers as of late.
It’s clear that opportunity is available for option traders around merger deals. At Masters in Trading, we provide the help you need to profit from these opportunities. Our Sunday Option Trade Plan is just one of many ways we equip our members with the knowledge and tools they need to reach success in trading options.