Does trading based on news and events work?

Event Driven Trading is any strategy that seeks to exploit pricing inefficiencies, occurring when companies are involved in corporate events such as mergers, takeovers, restructures (including share buy-backs, spin-offs and capital returns), de-mergers and lock-up expiries.

Traders, who follow event driven strategies, attempt to predict the outcome of a particular corporate event on the security price as well as the optimal time to commit capital. For example the recent failed private equity bid for Qantas would have provided opportunities for events driven traders.

Corporate and macro economic news announcements can have an impact on share price, particularly if the news is unexpected. Many analysts believe that corporate earnings revisions are the main driver of future share price performance. So a company such as Leighton Holdings, which has a history of over-delivering, would present event driven traders with an opportunity to buy quickly on an earnings announcement in anticipation of analysts upgrading their earnings estimates and fund managers increasing their weighting in the stock.

Another popular event driven strategy is merger arbitrage. The logic behind this trade is that many mergers involve share for share exchanges in a given ratio, i.e. “Company A” (acquirer) offering so many shares for “Company B” (target). For example Company A is trading at $10 and Company B is trading at $9.00 and the share exchange is 1 for 1. So the event driven trader will simultaneously sell shares in Company A and then purchase Company B shares, knowing they will receive shares in company A if the merger proceeds. The profit would be $1 per share. The risk is that the outcome may change if, for example, Company C enters the fray and offers a higher price for Company A or that the merger doesn’t go ahead.

The recent merger of two exchange giants, the Australian Stock Exchange (ASX) and the Sydney Futures Exchange (SFE) is a great example of a merger arbitrage opportunity. During much of the offer period SFE shares traded at a discount to the ASX offer, partly because of the perceived regulatory risk the merger may not being successful. Many event driven traders would have used a probabilistic model to assess the risk of the merger not proceeding. If the risk of the merger failing was low, then opportunistic traders would sell ASX shares and buy SFE shares.

Another event driven trading strategy involves corporate de-mergers and share lock-up periods. A recent trend to emerge, particularly in Europe, is the process of listed companies floating (spinning off) their subsidiaries. This is based upon the theory that the sum of the parts is often worth more than the whole. When a company lists one of its subsidiaries on the market, but retains an interest, it is common for there to be a lock-up arrangement over the remaining stake in an attempt to re-assure potential investors that the market is not about to be flooded with cheap stock (a similar arrangement takes place in IPOs).

Event driven traders can benefit in a number of ways from corporate de-mergers. Firstly, they will buy the parent company in the expectation that the share price will benefit from the de-merger process. If the strategy is correct, once the de-merger takes place, they will dispose their holding at a higher price than the original entry price. Then, a short time later, they will seek to exploit the lock-up period (usually founder shareholders/private equity (insiders) can sell down their stock holdings 180 days after the initial share offering). They do this by short selling stock, often using CFDs, ahead of a lock-up expiry and then buying back their short position at a lower price once the insiders have off-loaded their shares.