Only in an ideal world, and most of us don't trade in one. In years of profitable pairs trading I had very few pleasant surprises from takeovers, despite using a model that, as Don Bright hinted at, accepted takeover risk as part of the game and adjusted risk accordingly. A combination of typical pairs trading behavior and market forces take these trades away from you. Here's how: Pairs traders most often are expecting reversion to the mean for their profits. They target trades where price relationships have moved away from recent or historical averages by a certain amount and are expected to return to "normal". Trades must typically conform to a price model that has both a technical component (the magnitude of current price extension, for example) and a fundamental component (Market cap, measures of valuation, etc). To profit from a takeover surprise one must, obviously, be long the acquired and short a hedge against it on the day the announcement is made. (alternatively, one could be short the acquirer and make a little money, but there's more to be made long the acquired) Takeovers, meanwhile, don't happen in a vacuum. People know when talks or negotiations are underway, and stocks move accordingly -- especially small ones. Not only does our hypothetical gift long have clear value before talks begin, reducing the probability that it's beaten down in price enough to have a streched spread relationship with a given peer, but after talks begin the price of the potential target will strengthen even if nothing obviously illegal is taking place. Where does that put us in terms of price on the announcement date? The vast majority of the time it puts us in a spread that only conforms to part of the trading model, or perhaps none of it, and therefore has been passed on, already exited, or not identified. The reality is that, as a pairs trader, you're very unlikely to be in a takeover the right way when it occurs unless you're speculating in them. But takeover speculation is a different game -- home runs, not singles -- and if that's your thing you probably don't want, nor do you need, pairs. As an aside, I think Don Bright paints an image of the effect of takeovers on pairs traders that is too, well, bright. Both hooked2000 and I were critical of some of his comments on the Opening Orders thread regarding a recent hotel merger, saying that his claims about how well his guys did on that seemed unlikely. He hasn't yet responded.
As an aside, I think Don Bright paints an image of the effect of takeovers on pairs traders that is too, well, bright. Both hooked2000 and I were critical of some of his comments on the Opening Orders thread regarding a recent hotel merger, saying that his claims about how well his guys did on that seemed unlikely. He hasn't yet responded. Sorry if I missed something, as you see I try to respond to whatever I can on ET. Let's see, from a cursory review. DO/RIG - we were long RIG when it bought GSF, and RIG actually went up a few dollars, good results. HLT/MAR - long HLT, and it's was bought with a 40% premium, good results APPB/CMG - Long APPB, good results. AQNT/ELNK - Short AQNT - Not good results (it happens, LOL) OSI/DRI - Long OSI, good results SWFT/JBHT - Long Swift, good results. TRB/GCI - long TRB, good results. I'm sure this is not all recent "deals" - I just asked for what we have in our portfolio recently. And, FWIW, I don't take negative comments too seriously, I try my best to respond. I do what I can. Don
the pair was actually trending up(if al was used first). so if you followed the trend you would have made a killing
I have been trading pairs for along time, and let me say this, If you are trading pairs as a mean reversion strategy, it's highly unlikely you'll be on the correct side of a BLOWUP move. For instance, look at BA vs any of it's competitors pre 9/11, overnight you are out of business, and I know traders who were put out of business by that move. How about FNM FRE, in 2003 when the infamous ceo diary wasn't disclosed, and the spread blew out $8, again, I know traders that are no longer trading because of this spread. Mkts "know" things once in a while, and if you are committed to your positions, you are going to wake up one day with a nice blow up in your face. You can diversify, and trade smaller size, but for most traders, it's not an effective allocation of time or money. If you have any other strategies, such as OPG, Intraday Scalp, Momentum, etc, trading and investing in a few hundred shares of a pair is definately not worth the cost of other lost trading opportunities. The solution, Trade pairs, but don't invest. Leave the investing for the big boys like the Brights who can take the heat and inevitable blow ups.
this is why you have to have a stop lose. i knew a guy that lost over $150k pairing enron with I think EL PASO GAS. ouch.
Stop losses don't help you during blowups. And that Enron guy must have wanted to lose money. For one thing, Enron wasn't a good long with EPG on a fundamental basis, so his model was flawed. For another, Enron looked like crap when charted against anything in the peer group. When a stock doesn't chart well vs anything that should be a red flag for a pairs trader. At the time of Enron's collapse I traded pairs for a group at the Chicago Merc that had a bunch of floor traders downstairs and eight screen guys upstairs -- all of whom had moved from merger arb to equity pairs. All of us pairs guys were free to trade whatever we liked. Not a single one of us put on a single share of Enron against anything. It was that obvious a piece of shit. Just don't ask about Providian Financial...
My stop lose is to Trade pairs....not invest in them! Blow ups happen at once, as a previous poster pointed out, nothing you can do about them except try to get over that sickening feeling in your stomach when you realize that your pair blew out 10 points overnight!
Well said Mike. You should come up to Vegas when you get a chance, especially when Rob and my brother are strategizing - check out some of the constanty changing safeguards and tools we're using. Don