Pawleys Binary Event Trade

Last week, a client asked us to review the choices within her 401(k) plan at work to identify the best investments available.  The line-up included 9 different funds and also company stock.  There is a pending buy-out of the company, so when we initiated the review of the stock we anticipated that the stock would be trading at parity with the buy-out price.  The buy-out offer contains a combination of cash and shares of stock in the acquiring company.  The board of directors and shareholders of both companies have already approved the transaction, which is scheduled to close in the next several months.

Much to our surprise, the company stock of our client is trading at a 35% discount to the buy-out level.  Clearly, the market does not believe the transaction will complete.  The merger is being reviewed by the Department of Justice for anti-trust issues.  Recently, several high-profile mergers have fallen apart amidst government anti-trust concerns, including Office Depot & Staples, Sysco & U.S. Foods, and Halliburton & Baker Hughes.  We classify a pending buy-out which may be blocked as a binary event.  There are only 2 possible outcomes: either the companies will merge, or they will not.  Let’s be clear before we continue the story – the client was not in possession of material non-public information, and the trading window on the company stock for employees was open.

Typically, the best way to participate in a binary event is to place a straddle with option contracts.  This position is constituted by calls and puts with the same strike price and expiration date (which in this case would be just past the scheduled close date of the merger).  If the deal falls through and the stock falls or if the deal closes and the stock rises, the straddle holder profits.  Philosophically, we do not advocate the use of derivatives, so what did Pawleys recommend to the client?

As we reviewed the stock, we like their fundamental financials and the valuation of the stock, and were happy to recommend a long position to the client regardless of the outcome of the pending merger.  But what if the client is not confident and wants to enter with a more conservative strategy?  The client commits an amount of cash to the strategy and we use 50% of the cash to buy the stock.  If the deal closes, our profit is limited since we did not initially invest the full amount of cash.  But if the deal falls through, we take the remaining cash to add to the long position, averaging down the cost basis, and hold the stock.  This is how Pawleys trades a binary event in a more conservative way.  Ultimately, we went all-in as we feel the stock is high-quality and want to own it even if the deal fails.

© 2016 Pawleys Investment Advisors, LLC. All rights reserved.

 

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