What is M&A?
Mergers and Acquisitions (M&A) are common in the business world. Considered together, M&As refers to two companies combining their operations to achieve more efficiency and profitability. However, mergers differ from acquisitions, especially considering how they happen and the reason for happening.
When two companies merge operations, they intend to form a single operating unit with better capital and labor. Often, mergers happen between two companies with relatively the same standing in terms of operations and asset base. Even then, the nature of the merger can be described based on the companies involved. A horizontal merger includes two or more companies whose products are similar. These companies service the same market using the same technology and marketing techniques.
Vertical mergers happen along the supply chain; for example, a producer merging with a supplier of certain raw materials. On the other hand, concentric mergers involve companies focused on different product lines but servicing a similar audience. Lastly, a conglomerate merger brings together companies with differing operations, products, and audiences. The result of such a merger is a multi-focused company.
Unlike mergers, acquisitions usually entail the buying company folding the acquired into its operations. In this case, one company ceases to exist while the other remains unchanged. Examples of hostile acquisitions abound, where the buying company takes over the acquired company with its express consent.
Why M&A offer a profit-making opportunity for a trader
No matter the nature of the M&A, there is always a profit-making opportunity for a trader. Consider an acquisition where two companies agree to join forces where Company X shall fold into a unit of the company upon closing of the deal. Assuming that before the merger, each of the companies had a different stock price, say Company X is worth $20 per share, and Company Y is worth $50 per share.
In such a deal, the acquirer states the price at which it is willing to pay for the acquired company. Along the way, however, another company might submit a better bid for the acquired company. If Company X is acquired, and Company Y is willing to pay $25 per share, then Company X’s stock price should trend at $25 on the day the deal closes. Therein lies a profit-making opportunity for a trader.
In investor-speak, betting on the stock price differential is a strategy referred to as merger arbitrage. Consider the investor who buys Company X’s stock immediately after news of a potential merger break. At this point, Company X is still worth $20 per share. Five months later, the deal closes, and Company X’s value jumps to $25 per share, which is the acquisition price. The lucky investor might just have made a significant profit by earning $5 on every share bought, of course, minus fees and commissions.
There could be another opportunity to earn income from the deal. Often, investors bet against the acquirer’s stock in an acquisition. The same investor could have shorted company Y’s stock by say $3. On closing of the deal, company’s stock is likely to fall because it is taking on a burden that has a downward pressure on its value. The ensuing volatility in both companies’ stock price is a lucrative but risky opportunity for arbitrageurs.
How to trade M&A stocks intraday
For starters, intraday stock trading is high speed. It involves taking on small profits but several times such that the accumulative effect yields comfortable returns. Intraday trading of M&A stocks could exploit the pre-acquisition volatility that sets in. The volatility is usually high, especially around the time when details concerning the deal become public. Around this time, the takeover target’s stock price rises while the acquirer’s stock declines, such as happened in Company X and Company Y in the above illustration.
To exploit this opportunity, one should first note the takeover price. Often, the takeover price is higher than the target company’s market price to entice shareholders into Okaying the deal. Once a takeover rumour hits one’s ear, it is time to act. However, it is prudent to wait for a short time pivot before making the trade. This way, one will exploit the short-term volatility triggered by the takeover rumour. Even then, always take care to cover the trade’s underside because not all takeover rumours happen.
To do so, put in place sufficient stops to mitigate any losses that may arise. A trailing stop is ideal to ensure that a profitable opportunity is not left to go unexploited. However, these stops should not be too tight as to be triggered by a minor correction.
Why M&A could be an excellent opportunity to short intraday
Short selling is a popular strategy for day traders. But what exactly is this strategy? Shorting a stock or merely short-selling entails selling high and buying low. A trader who is confident that a certain stock’s price will fall borrows the shares from the broker and sells. If the trade goes as planned, then the trader buys the stock at the agreed point of return at a lower price.
In intraday trading, this is an excellent strategy for trading M&A stocks. When reports of an impending takeover break, investors rush to buy the target company’s stock. Meanwhile, the same traders go to extra lengths to hedge their positions at the proposed takeover price. But since M&A deals take months, even years, to complete, a certain level of volatility strikes the stock price. Consequently, numerous opportunities for intraday shorting arise.
Shorting is even more profitable if the parties to the deal end up canceling it. In the meantime, every piece of news that emerges concerning the deal moves the stock. To respond to resulting stock price fluctuations, traders continue to cover their positions hence leading to short-term pivot points. All these pivot points are ideal short opportunities for exploitation.
Mergers and Acquisitions are especially common in an active market where businesses are looking for opportunities to deliver more value to investors. Given the complexity involved, M&A stocks exhibit heightened volatility. This kind of volatility makes the stocks unattractive for long positions. Intraday trading takes advantage of the fluctuations that result from activities of traders covering their positions while trading M&A stocks. Therein lie short opportunities.
Nonetheless, trading M&A stocks is a high risk. In the first place, not all takeover deals close. The moment that such a deal collapses, a flurry of activity breaks as traders move to cut their losses. In the process, one may end up losing vast amounts of money. Secondly, shorting M&A stocks in intraday trading takes huge amounts of time strategizing. One might need advanced details of the deal as well as advanced knowledge of both technical and fundamental analysis. Therefore, it is prudent to warn that trading M&A stocks intraday is a preserve of professional traders.
Even then, such trades require the highest level of conscientiousness. A professional trader or not, one might want to make good use of stops and other means of hedging such positions. One just never knows when the market could plug in a position.