Using options instead of stocks for merger arb: Apparently not for the faint of heart

With corporate balance sheets flush with cash, there has been a lot of talk recently about the potential for an M&A bonanza.  This, of course, would provide opportunities for merger arbitrage hedge fund managers.  Whether you consider their returns to be a fair compensation for long the successful completion of deals or the result of pure skill, research has shown that merger arb has produced positive returns over time.

We noted in late 2009 that merger arb has shown a particularly high correlation to the S&P 500 in recent years.  And academic studies have shown that “arbitrage spreads” have been falling since 2002.  Some say this is emblematic of a growing capacity constraint in the strategy.  But regardless of their source or recent declines, merger arb returns have averaged around 1% per month over several decades.

Merger arb funds provide “insurance” against deal failure by going long the target and short the acquirer, under the assumption that prices tend to converge before they merge.  But you can also set up merger arb trade by using options.  In fact, previous research cited in a new academic paper found that according to one survey, 20 of 21 arb managers actually did that.  Yet most academic studies are based on a “classic” merger arb style that uses equity positions only.  The new academic study (“Profitability of option based merger arbitrage” by Haitao Li of the University of Michigan and Xuewu Wang of the University of Scranton) actually concludes that a passive options-based arbitrage strategy is “a lot more profitable” than a stock-based one.”

Li and Wang set up two passive strategies – one using stocks and one using options – and pit them head to head in a horse race beginning in 1996 and ending in 2008.  To ensure an applies-to-apples comparison, the strategies only trade deals where there are options available on both the target and on the acquirer.  Further, they only look at cash and stock offers (not complex offers that include warrants or collars).

The stock-based strategy does remarkably well, producing a return of 130 basis points a month.

The options-based strategy simultaneously goes long call options on the target’s stock and long put options on the acquirer’s stock.  If the deal succeeds, the target’s stock will increase, making it’s call options more valuable and the acquirer’s stock will fall, making it’s put options more valuable.  If the deal fails, the opposite will happen and the options may expire worthless.

But wait, you say, what about the other factors that determine the value of an option?  Volatility, for example.  As Li and Wang point out, an options-based merger arb strategy bets not just on equity price movements, but on options price movements, a “vastly different” thing.  Options buyers, for example, can also choose between options with different liquidity and leverage, allowing them to amplify returns (and volatility).  In fact, the passive options trading methodology used by Li and Wang seeks out “options with the greatest price change for a given change in underlying stock prices.”

The other wild card when using options for merger arb trades is that you don;t know when the deal might close.  The liquidity/leverage-driven algorithm used by Li and Wang placed trades in options with an average maturity of 113 days for calls and 53 days for puts.  But the average time to close each deal was 125 days.

Here’s how the horse race went between stock-based and options-based merger arb algorithms…

The stock-based approach did okay, with a monthly return of 0.84% with a daily standard deviation of 1.17%…

But the options-base approach posted an average monthly return of 1.32% with rather eye-popping daily standard deviation of 2.25%…

That return is after a death-defying fall from being 4500% up to being only around 1700% up.  Unfortunately, Li and Wang give this roller-coaster only a passing reference:

“While we don’t analyze the cause of this decline further, we notice this time period coincides with the market downturn caused by the subprime crisis.”

This begs the question of whether the higher return is simply fair compensation for higher (and highly intermittent) volatility.  The duo adjusts these raw returns for Fama French factors and concludes that:

“…while both strategies generate significant abnormal returns that are robust to asset pricing factors, option-based merger arbitrage is more profitable than stock-based merger arbitrage.”

…As long as you don’t wear a pacemaker of have some kind of panic disorder.

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3 Comments

  1. caveat bettor
    October 26, 2010 at 4:18 pm

    May need correction: ‘Further, they only look at cash offers (not complex offers that include warrants or collars)’ above seems to conflict with p4 ‘… we only examine cash and stock offers’.


  2. caveat bettor
    October 26, 2010 at 4:43 pm

    After reviewing their methodology, I suspect the perceived alpha in the options approach may not be real. On p.5, we find that they use the mid-price, between the bid and the ask provided by OptionMetrics to approximate trading levels for their options backtest.

    This is not realistic. Let’s take an anecdotal look at a one deal that would fit in the universe created by Li&Wang’s methodology: McAfee Inc (MFE). It is a $48 offer for holders of the stock, closing at $47.32 today, with nice liquidity with an average of 5 mil shares trading daily. And it’s got listed options on it. Coincidentally, the average price for an S&P500 stock is $47, so strike prices on the listed contracts will be comparable within the universe.

    MFE has traded at an average of $47.22 since the announcement of the INTC acquisition. Good luck capturing that 78 cents with options (vs. stock), unless you are also actively trading gamma, theta, and vega.

    The issue is, MFE options do not trade with any liquidity, especially at midprices. Today, for instance, a total of 176 contracts traded in the December expiry contracts, which was the most for any expiry. These trades were contained with the 37 (2), 47 (34) and 48 (105) calls and the 40 puts (35)–number of contracts traded in parentheses. The other 32 listed Dec contracts did not trade today.

    The spreads between mid and bid, and mid and ask, can easily exceed 1% or 2%. A more realistic approach would be what most traders need to do to implement their strategies: to buy the offer, and to sell the bid. Sure, a trader will get filled (and paid) for providing options liquidity. But most merger arbs are not about providing options liquidity–they are taking it, and listed options desks get paid to provide liquidity and take risk to facilitate these trades.

    Li&Wang choose the most liquid options for their strategy. But its not possible to use the most liquid contracts when the deal is announced, because no one knows which options will trade the most through the life of the deal. This is another uncertainty in the implementation of the theory.

    Crossing the spread to implement the discussed strategy will pretty much eliminate the additional profits claimed by Li&Wang. I would not be surprised if the ‘realistic approach’ of market buys to ask and sells to bid would underperform. Of course, an advantage of employing options bring over stock is the greater leverage of the former, which can make the return on capital look more favorable.


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