(and How to Make Money off the Fool’s Gold)
One of the big stories this week was that the U.S. Treasury Department announced new rules that would limit companies’ ability to participate in inversions. The new rules put the Pfizer (PFE) and Allergen (AGN) merger in peril. And I took an interest in this because I had an open position in PFE, owning call options (a bullish position) since January.
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So why did the ruling play such havoc with the PFE, AGN and even the market as a whole? It’s all about a case of Fool’s Gold and many hedge funds that took the bait. Here’s what I mean.
Many traders and large hedge funds trade strictly in Merger Arbitrage. These traders look at deals that have already been announced, and then examine the deal terms and the levels the stocks are trading. If they think the chances of the merger going through are great, but the stock being acquired is trading below where it “should,” they see opportunity and will often buy shares (or call options or some other bullish position).
In the case of PFE/AGN, there was plenty of “opportunity.” The day before the Treasury’s rule changes, AGN closed at 278; based on the details of the deal if PFE and AGN were to merge, the stock price would be around 340. Thus there was $62 of potential gains! This opportunity was so large that as of the December 31 filing, AGN was the top holding of hedge funds, with 80 of the funds holding AGN as a top-10 position. Imagine!
Fast forward to day the new rules were announced. With so many funds caught on the wrong side of the trade, AGN plunged $41 that day, and while it’s bounced a bit since, shares remain damaged. Clearly many hedge funds sold their AGN—and that means they also closed the rest of the trade, which meant covering their shorts on PFE. Sure enough, PFE has surged about 10% during the three days since the rules came out and the deal was called off.
What will be interesting is whether these unwinding has a larger impact on the broad market -- with so many funds having taken big hits on their long AGN/short PFE position, it’s not unreasonable to think many might have to raise cash by lightening up on other stocks to stop the bleeding. Interestingly, the market has been all over the map since the deal fell apart, falling sharply on Tuesday and Thursday, with Wednesday producing a big rally.
Last year, something similar happened when the AbbVie (ABBV)-Shire (SHPG) deal fell apart. Like the PFE-AGN arbitrage, the ABBV-SHPG arbitrage was a very large hit for many hedge funds, but that only caused a couple of bad days in the overall market before things stabilized.
As for my calls, the rush into PFE stock obviously has helped--subscribers had been taking some pain on this position during the past several weeks, but the rush higher made it a profitable trade. I’m looking to take partial profits on the way up and hopefully ride the rest for further gains. It will be interesting to see how the stock performs in the coming days/months as the shorts are no longer pressing on the stock and may be forced to cover.
Whatever happens, let this episode remind you of two market truisms. First of all, there is no free lunch--when you see something in the market that’s too good to be true, it usually is. And second, remember that there is always the risk of a bad outcome; in this case, many of Wall Street’s smartest minds forgot that, and they lost big money as a result.
