Why the Stock Market Doesn’t Matter
ArbitrOption’s investment strategy is designed to be insensitive to the ups and downs of the stock market. While the universe of investment opportunities is infinitely variable, our deal-related investments have a very narrow set of outcomes. That’s why we can use options to gain exposure to specific stock outcomes, yet have a low correlation to the ups and downs of the stock market at large.
The Stock Market Is Infinitely Variable
Suppose we were long-short investors, attempting to outperform the market. We might try to forecast which industrial sectors will gain and which will fall so we can profit. But over what timeframe, and how do we know when to give up on a bad investment? Are we trying to outperform the general market in one month, one year, ten years? Even if we had a specific date in mind, the range of possible stock values is enormous.
Research: Stocks with Announced Events Have Only Three Unknowns
On the other hand, when there is a publicly announced event pending for a stock, like a merger or spinoff, there are only three unknowns:
- Will the event actually happen?
- How long must we wait for the event to happen (or fail)?
- What is the stock’s value when the event is done? How much if it succeeds, how much if it fails?
Take the example of the management buyout of Qihoo 360 Technology. The company announced an acquisition, with a per-share transaction value of $77. Here’s how we answered those three questions:
- Yes, because antitrust approval is nearly certain, and the foreign exchange and shareholder approvals are likely based on similar precedent transactions.
- By the end of September, based on the timeline for approvals set out by prior transactions.
- We estimated that Qihoo 360 would fall to $44.46 if the deal was terminated, based on the performance of a basket of comparable stocks. If the deal succeeded, the stock would be worth $77.
None of the answers are certain, but there is a much narrower set of outcomes than a general stock investment. With our answers, we can pinpoint a specific date in time, a likely stock value if the event happens, and a likely stock value if the event does not happen.
Trading: Options Can Help
Thanks to that narrow set of outcomes, publicly traded options offer an effective way to gain exposure to the narrow outcomes we predict.
How We Are Exposed to the Market
Our strategy is not completely immune to the market. The biggest factor is how market movements affect question 3, a stock’s likely value if a deal falls through. However, only 7% of deals have fallen through in the past 20 years. At the peak of the financial crisis in 2007, 17% of deals by dollar value were canceled. Since ArbitrOption was formed in 2009, fewer than 25 deals, out of more than five hundred investments, have fallen through.
Low or Negative Correlation to the S&P 500, by Design
Our historical correlation to the market is low, and that’s not by chance. It’s because the structure of our investments, and the way in which they gain or lose value, is only slightly exposed to the day-to-day movements of the stock market. So even if the market is losing value or staying flat, we are still able to apply our process, ensure our risk is defined, and work to generate profits on behalf of our investors.