- The consensus on Wall Street is that merger and acquisition (M&A) activity is going to accelerate after a relatively slow 2017.
- The derivatives team at Goldman Sachs has outlined how investors can use options to both identify and capitalize on M&A speculation.
Companies are usually purchased at a premium to their current market value, which leads to a stock surge as investors rush to close the pricing gap. With that in mind, it would seem that the best possible way to trade on M&A speculation would be to simply buy shares of potential targets.
Not so fast, says Goldman Sachs. Katherine Fogertey and the rest of the firm’s derivatives strategy team thinks you can do a whole lot better than that.
But before we get into their recommendations, let’s first look at what’s at stake. Many Wall Street firms — including Goldman, Bank of America, Wells Fargo, and Robert W. Baird — are in full agreement that M&A is due for a major pick-up this year. Their optimism comes on the heels of a disappointing 2017 that saw global mergers fall 9%.
The general consensus is that tax reform will be the major driver, given the huge glut of repatriated cash flowing back into the US from overseas. Going off that, Goldman recently forecast a 6% increase in cash M&A spending to $355 billion in 2018.
So what’s a trader to do? Goldman has identified two crucial steps for investors to consider.
1) Identify whether an M&A premium is already priced into a stock
Goldman’s strategy for identifying potential M&A candidates involves analyzing the footprints left behind by trades that investors do when they see high potential for a takeover. This is an important first step in identifying opportunities for stock price appreciation.
One way the firm does this is by looking at a measure called skew, which is the premium being paid for out-of-the-money (OTM) options. For this scenario, Goldman is looking for increases in call prices relative to puts, since investors buy short-dated calls to position for M&A-driven stock spikes.
Goldman also looks at term structure, or the trend of volatility being expected in the future. The firm notes that a decrease in long-dated options prices relative to short-dated ones is another signal suggesting investors are already positioning for a deal.
2) Make the following types of option trades to capitalize on opportunities identified during step 1
Goldman has two distinct strategies for expressing a view on M&A potential.
The first is the purchase of three-month OTM call options. And the second method is the sale of 12-month, OTM strangles — defined as the simultaneous selling of a slightly OTM put and a slightly OTM call of the same underlying stock and expiration date.
Better yet, Goldman says these trades become even more effective when used in tandem.
However, in the end, it’s important to remember that these trades are ineffective unless an investor is first able to locate soft spots in trader positioning. That’s why the two steps laid out above are so important. One leads nicely into the other — and they both hopefully lead to some big gains for M&A speculators.