Today’s topic is not specifically about an options trade - in that it doesn’t involve taking a direct position in listed options - but it involves many of the same principles.

Arbitrage: Buying an asset (or assets) and simultaneously selling the same or substantially similar asset(s) to take advantage of a price discrepancy and lock in a riskless profit.

The practice known as “risk arbitrage” involves simultaneously buying and selling shares in two companies that are the subject of a proposed merger deal that has not yet closed to take advantage of the expected convergence in their respective share prices.

The “risk” part of the name refers to the chance that the deal won’t occur and the share prices won’t converge. The difference between the deal price and the market price of the shares at any given point is a measure of the market’s level of skepticism that the deal will occur at the announced price.

Example:

Company ABC is trading at $100/share and announces their intent to purchase company XYZ (which is currently trading at $48/share) in an all stock deal at a price of 0.6 shares of ABC for each outstanding share of XYZ.

If the deal was certain to happen, you’d expect the price of XYZ to go to $60/share – or 60% of ABC’s current price whenever the price of ABC changes. Because the deal still likely faces a shareholder vote, regulatory approval, possible rival bids and a host of other unknowns, it’s more likely that the price of XYZ will rally part of the way to $60/share immediately and then creep toward the deal price as the likelihood of the merger being completed increases.

Let’s say XYZ rallied to $53/share on the day that the deal was announced and that you were fairly certain that it would be approved and close in a month. You could buy 1,000 shares of XYZ for $53/share and sell 600 shares of ABC for $100/share.

You’ll collect a net of $7,000 on the trade ($60,000 in sale proceeds minus $53,000 in shares purchased).

If the deal closes, 1,000 shares of XYZ will literally become 600 shares of ABC and you’ll have no position – except for that $7,000 in cash in your account, less any commissions, fees and interest. (We’re also assuming that we can borrow to buy stock and lend the proceeds of a short sale to earn interest at similar rates. This will figure into the story later.)

If the deal were to fall through however, the price of ABC and XYZ shares could diverge to almost any price. Because you are short ABC shares and no longer own a security that’s guaranteed to rally along with them, the risk is theoretically unlimited.

Hedge funds and large money managers often execute “risk-arb” trades because they have a tolerance for the risk and also the ability to monitor developments about the proposed deals in real-time.  They also tend to take on that risk with tens or hundreds of millions at stake. Obviously not all mergers are straight stock deals.

Merger deals often also contain a cash component, warrants and a host of other contingencies. A deal as mathematically simple as the one outlined above would represent such easy profits that sophisticated investors would gobble up those profits immediately - making it difficult for individuals to capitalize on it.

The more complicated the terms of the proposed agreement, the wider the spread is likely to be and the greater the chances for profit because of the increased risk.

In April 2019, Canadian Marijuana Producer Canopy Growth (CGC Quick QuoteCGC - Free Report) secured the right to purchase US Multi-State Operator Acreage Holdings (OTC: ACRGF) for $3.4B in cash and stock. The merger would give Canopy an immediate foothold in the much larger US market.

It wasn’t a simple deal, however. Though Acreage operates within the laws of the individual states in which it does business, marijuana remains illegal at the federal level, meaning Canopy could not own Acreage and maintain a listing on the New York Stock Exchange.

Canopy structured the deal so that it could be assured of owning its desired stake in Acreage in the event of US legalization without running afoul of exchange regulations by adding a contingency (essentially an option) to the agreement.

Canopy paid Acreage $300M in cash up front and will exchange 0.5818 shares of Canopy stock for each share of Acreage. The contingency is that the transaction will only occur if marijuana is legalized at the federal level in the US within the next 7.5 years.

Shareholders of both companies approved the deal by 99+% margins and no regulatory challenges are expected, so the deal essentially becomes an option on US legalization. If marijuana is legalized, a share of Acreage will almost certainly become 0.5818 shares of Canopy. If Acreage is trading below 58% of Canopy’s current price, the difference would represent the probability the markets assign to US legalization.

But there’s also a wild-card component to the price relationship – the interest rate you’d have to pay to be short Canopy shares.

On Tuesday, Canopy closed at $14.21/share and Acreage closed at $4.40/share. If you were certain that marijuana was about to become legal and the deal would close, you could make a significant profit by buying 1,000 shares of Acreage for $4,400 and selling 582 shares of Canopy for $8,270. If the deal hapened immediately, you'd keep $3,870. That’s a pretty tidy profit.

Easy arbitrage trades like that are extremely rare and don’t exist for very long.

The “catch” is that not only does marijuana have to become legal in the US – which is not yet a foregone conclusion – but it would have to happen fairly quickly because it costs a significant amount of money to maintain a short position in Canopy shares. They are heavily shorted and hard to borrow for new short sales. If the short rate is 20% annually, compounded nightly and it takes two year for the deal to close, you’ll pay more than $4,000 in interest charges, eliminating all of the profit on the trade.

The chances of US federal legalization got considerably more likely this week at the MORE Act was easily advanced by the US House of Representatives Judiciary Committee and appears destined for passage by the full House. The legalization cause got another boost Wednesday night when Senator and 2020 Presidential candidate Corey Booker (D, NJ) made an off-handed comment in a debate directed at former Vice-President Joe Biden about Biden's stated reluctance to fully legalize marijuana - which Senator Booker strongly implied was inevitable.

Cannabis stocks have rallied strongly over the past three sessions with some gaining as much as 40-50%. Importantly, the spread between Canopy and Acreage has barely narrowed. At mid-day Thursday, Canopy was trading about $21.20/share and Acreage shares were up almost 30% on the day at $6.60. Today, the same risk-arb trade as above would yield a potential profit of $5,700 per 1,000 shares of Acreage. (Buy 1,000 ACRGF for $6,600, sell 582 shares of CGC for $12,338.)

In practice, that’s a pretty sophisticated trade for the average investor, involving a lot of margin and interest rate considerations aa wel as the issue of how to manage the risk if the deal starts to unravel.

It does however present an opportunity even for a typical retail trader who doesn't want to sell shares short. If you think the marijuana stocks have bottomed and also that US legalization is right around the corner, Acreage Holdings is a much better value than Canopy Growth.  

Understanding the unique optionality of the deal is key to making that determination. Even if you're not directly trading options, option concepts are everywhere.

-Dave

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.