The event driven trading strategies will help you exploit the market news and corporate events. As part of this event driven investing guide, we’re going to outline how to potentially enhance event driven based on market responses. Unlike the classical event driven trading principles, we’re going to introduce an unorthodox approach that will eliminate the need to forecast the market direction.
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I think we can all agree that news moves the market price. There are many different events that can cause an asset's price to change. However, knowing in what ways the market will move that’s what will make you money. By assessing the probabilities of each of the potential risk events will allow investors to make an educated bet on the direction of the stock.
Now, the event driven investing strategies are typically used by hedge fund managers and large institutional investors. However, the same trading principles can be used by the retail crowd to take advantage of the pricing inefficiencies that can happen before or after a risk event.
Let’s begin by defining what event driven trading is and see how event driven funds make money.
What is Event Driven Investing?
Event driven investing is a type of investment strategy used by hedge fund managers that looks to generate returns by investing in opportunities arising from news events and corporate events.
Typically, these event driven factors include:
- Mergers and acquisitions (M&A).
- Management changes.
- Earnings call.
- Or any action that can impact the value of the stock price.
The event driven trading strategies are normally implemented through equities or credit securities such as bonds. There are different types of strategies in the event driven space. The two types of event driven investing are:
- Merger Arbitrage.
- Distressed debt.
The merger arbitrage strategy can be implemented when one company takes over another company. When this merger acquisition occurs, the target company will normally trade at a discount price.
However, there are factors such as regulatory reasons that can break the deal. So, a profit can be made only if the deal closes.
A good example of a good distressed debt trade was during the subprime mortgage crisis of 2008 when Lehman Brothers went bankrupt. Many distressed debt managers correctly identified that some good securities in this bankruptcy had quite a lot of value and purchased these securities at a deep discount.
The event driven strategy generally has quite a high correlation to equities.
For example, the event driven trading strategies are expected to do well in rising markets and offer some kind of protection in falling markets
Now, moving on…
Let’s study how event driven investing works.
How Event Driven Trading Works?
Event-based investing is all about finding a catalyst that can impact the stock price.
A catalyst is an event that can help unlock the value of a company. Event-related catalysts have very specific dates and potential outcomes, which gives you the ability to quantify them.
As an investor, if you find a stock trading at a discount price ahead (or after) of an event and you think the market mispriced the impact on the stock price you can buy the stock.
Now, we oversimplify the process, but you get the idea.
Let’s learn when is the best time to implement event driven multi-strategy.
When to Use Event Based Investing?
The best time to use event driven trading is when the economy is booming.
Do you know why when the economy is performing well, event driven trading also performs well?
Because, this is when the corporate activity is busiest, which in turn will provide investors with lots of event driven news and event-driven investing ideas. When the economy is doing well, the correlation between specific events and asset prices will be stronger.
Next, we’re going to look over some event driven strategies to take advantage of known events.
Event Driven Trading Strategies
To construct an event driven strategy, you should focus on companies’ specific events that affect equity prices.
When introducing the concept of market response we look for ways to interpret events in a dynamic framework. More specifically, we consider how the market view on a particular event may change over time depending on the market sentiment.
As part of your research if you want to capture such changes in the stock price you should study the most recently observed market responses to any given event types.
Let’s highlight some successful event driven trading strategies that you can implement.
A 3 Step Process to Event Driven Investing
So, how event-based investing work?
The first step is to select the most stocks that typically bound in news announcements and are liquid. We only count for the relevant news that has the potential to trigger some volatility.
Example: use the free stock screener offered by Finviz to scan for liquid stocks. E.g. we scanned stock with average volume over 1M.
The stock scanning results give us 1466 stocks to choose from.
But, we need to narrow down our options.
What events to use for finding trading opportunities.
Broadly speaking, any event that has the potential to change the stock price is a tradable event. But, not all events have the same power over the price action. Some are micro-events and others are macro events that are long-lasting forces that can generate trend momentum.
The micro events are specific to an instrument like an earnings report. These micro-events will be important for the outlook and projection of the stock price in the future.
Let’s filter out the stocks that had earning reports the previous week.
See the stock scanning results below:
We have narrowed our stock list down to only 145 stocks.
Now, let’s see how to interpret the earning reports for ticker symbol HSBC.
In the last step, we take the average stock return over the past x number of events. We only want to take into consideration the most recent news events. These are more relevant for an accurate read of the stock price.
The market can produce a more predictive response with certain events than the other. So, through this step, we can monitor which events have a higher probability to make us money.
Here is what you have to do, study how the HSBC stock price reacted to past earnings reports. Based on the daily market response signal for the earnings report a long or short position is entered.
If you can’t find a predictable outcome of a certain type of event, look for another stock or other risk event until you can find a clear pattern.
We can observe after the actual event how the market reacted
Being able to distinguish between event types will allow us to understand the corresponding risk and return pattern.
If you study the past reactions of HSBC to earnings reports, what can you notice?
Hint, the stock price sell-offs (see the stock chart below):
So, what do you think it’s this a predictable pattern?
Of course: YES!
The smart way would have been to position yourself with a sell order before the earnings report announcement so you can take advantage of this event driven pattern.
Now, one thing to keep in mind…
Event interpretation can change over time. The interpretation of certain event types can depend on the prevailing market sentiment.
But, how can we measure the market sentiment?
Here is one idea that might work…
We can simply construct a news sentiment index. Alternatively, we can simply look at the market response.
What do we mean by this?
What was the stock price reaction with companies that have recently gone through the same type of event?
Is this approach the Holy Grail?
Not necessarily, but it can provide valuable input on the cause (sentiment) rather than the effect (price).
If a company is announcing layoffs, the next legitimated question you should have is: why?
Obviously to cut down cost.
But moving one step forward, what is the underlying reason for cutting costs?
There are two answers:
- Is it simply to make the business more efficient and thereby improve the bottom line
- Or, it’s for the company to survive
Each answer can produce a different outcome for the stock price.
So the market environment can help us understand what reason is the most likely scenario.
This type of event strategy can work when the news catalysts aren’t clearly good or bad.
Sometimes it’s difficult to isolate the effect of individual events over the big picture so it’s best to stay out of the market in those situations.
The next event driven investing strategy has an unorthodox approach that is easier to capture.
Event Driven Investing at the Expiration of Options
The market events like an option expires can provide us with good potential opportunities.
The options that are very active at the expiration day can trigger substantial movement in the stock price
So, how options expiration affects stock prices?
The options trading activity on the last day before expiration can have a direct impact on the stock price.
To better understand how options expiration can impact the stock price, let’s go through an example.
Let’s assume investor Joe, sold 100 Tesla put options with a strike price at $700.
Selling 100 put options obligates Joe to buy 10,000 Tesla shares from the put owner.
We have two scenarios:
- If Tesla shares trade above $700, the options expire and are worthless, so investor Joe gets his premium.
- If Tesla share trades below $700 and the owner exercise its option this will leave investor Joe long 10,000 Tesla shares and with a loss at the start of trading on Monday.
Big institutional investors won’t like the exposure to that type of risk so they will try to buy Tesla shares at the current market price. But, they will buy in big volume to apply sizeable pressure on the stock price to move back above the $700 per share.
This back and forth action to try to defend the option strike price is a good event driven trading opportunity. If you know that someone is trying to defend options you can then try to use that event to capitalize on it.
Final Words – Even Driven Investing
In summary, event driven investing has the potential to generate profits in both bullish and bearish scenarios. Our event driven guide can help you implement these types of investment strategies, but the difference between success and failure requires a good analysis of each event individually.
The main challenge behind event driven trading is that when an event occurs that affects the stock price the reaction in the market can be sharp. That can make it difficult to execute your trade once the market started to move. Luckily for you, with our event driven trading strategies you can position ahead of time and profit from this event driven moves.
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