Event-Driven Trading Strategies (Event-Based Trading – Backtest Insights)
With investors becoming more concerned about their risk-adjusted returns amid bearish and flat market environments, interest in event-driven strategies has gained momentum. But what are event-driven trading strategies?
An event-driven strategy is a trading approach that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as an earnings call, bankruptcy, merger, acquisition, hostile takeover, or spinoff.
With this strategy, an investor attempts to take advantage of temporary stock mispricing that occurs before or after a corporate event takes place. An event-driven trading strategy is presented at the end of the article with a complete backtest.
In this post, we will take a look at event-driven strategies.
What is an event-driven strategy?
An event-driven strategy is a trading approach that seeks to exploit pricing inefficiencies that may occur before or after a corporate or news event. Examples of such corporate events include bankruptcy, mergers, acquisitions, hostile takeovers, corporate restructurings, spinoffs, or even an earnings call. An example of a news event might be the monthly Jobs report published on the first Friday of the month.
With this strategy, an investor attempts to take advantage of temporary stock mispricing that occurs before or after such a corporate event takes place.
This strategy is mostly used by private equity or hedge funds because it requires the necessary expertise to analyze corporate events for successful execution. While the strategy tries to exploit the tendency of a company’s stock price to suffer during a period of change, there are different types of the strategy, namely: merger arbitrage, convertible arbitrage, special situations investing, activist investing, and distressed investing.
Hedge funds that use event-driven strategies employ teams of specialists who can expertly analyze corporate events and determine the effect of such events on the company’s stock price. They look at the current regulatory environment, assess possible synergies from mergers or acquisitions, and then consider a potential price target after the action has taken place. With that, they would decide how to invest, based on the current stock price versus the likely price of the stock after the action takes place.
Is event-driven strategy the same as special situations investing?
Not exactly. An event-driven strategy is a broad term that includes special situations investing and other types of strategies. Simply put, special situations investing is a type of event-driven strategy. It refers to opportunities that arise throughout a company’s life created by special corporate situations that can drive the price of the company’s security towards a new value.
Such situations can arise from events like spin-offs, mergers, acquisitions, business consolidations, liquidations, reorganizations, or bankruptcies, which may affect the valuation of the company’s security (stocks or bonds). In this case, the securities of the underlying company could be purchased under the expectation of a long-term turnaround or to profit from bets on events such as share buybacks, credit rating changes, regulatory/litigation announcements, and earnings reports.
What is event-driven arbitrage?
Event-driven arbitrage is a form of event-driven strategy that presents arbitrage opportunities. There are two types: merger arbitrage and convertible arbitrage.
In merger arbitrage, an investor actively pursues M&A targets to purchase securities of companies subject to an acquisition or merger at a discount to the offer price — that is, to trade the premium on announced acquisitions. The investor goes long the stock of the company being acquired and at the same time, sells the stock of the acquiring company.
Convertible arbitrage, on the other hand, refers to a technique of profiting from pricing inefficiencies between a company’s convertible securities and its common stock during periods of a special event. Here the investor takes a long position in the convertible security and a short position in the common equity.
Event-driven strategy example
Whenever a merger/acquisition is announced, the stock price of the target company (the one being acquired) typically rises, while that of the acquiring company is likely to drop if the acquiring company plans to use its stock to fund the acquisition. A skilled investor can take advantage of that by assessing the likelihood of the acquisition going through, based on a host of factors, such as price, regulatory environment, and fit between the services (or products) offered by both companies.
If the investor is convinced that the acquisition would happen, he can go long on the stock of the company being acquired and go short on the stock of the acquiring company. Say company A trading at $20 per share wants to acquire company B trading at $10 per share. An investor can buy stock B and short stock A. he would close his trade at the proposed acquisition price.
Event-driven hedge fund performance
It depends on the year. Sometimes, the performance was as high as 42% returns in a year, which is much bigger than the S&P 500 average return of about 10%. It seems the health sector contributes most of the gains from event-driven methods.
President Obama’s US healthcare reforms led to regulatory uncertainty in healthcare, which created many mergers and acquisitions with accompanying event-driven opportunities. In 2015, about 60% of event-driven hedge funds’ gains were from the sector, according to Alan Davis Wealth Management.
Even-driven trading strategies (backtest)
An example of an event-driven trading strategy with trading rules and settings is to backtest the performance of S&P 500 on the day of the monthly Jobs report.
The Job report is normally published on the first Friday of the month (on the second if Friday is the first day of the month) by the US Department of Labor. The report’s main numbers are nonfarm payroll employment and the general unemployment rate and is widely regarded as the most important macro number because it sets the interest rates and thus indirectly influences the stock market.
We backtest the following strategy and rules:
- We buy the open on the day of the Jobs report,
- and we sell at the close of the same trading day.
The equity curve of the strategy looks like this:
The statistics and trading metrics tell us that the average gain is 0.09% and the win rate is 55%. This is much better than any random trading day, but not enough to trade it (in our opinion).
Those who are regularly reading this website know that practically all of the gains in the stock market have come from the close until the open the next trading day. Compared to this fact, the gains of the Friday Jobs report are pretty good.
We have separated the different gains from the close-to-open and open-to-close in a previous article:
This is just one simple idea of how you can backtest an event (no matter what it is). If you are new to backtesting, you might be interested in our inexpensive backtesting course.
List of trading strategies
This article is just of more than 800 we have written on this blog since 2012. The majority of the articles contain backtests with specific and testable rules, and we have compiled many of those into a package of code that you can order. We have thus far over 160 different strategies in the compilation.
The strategies are taken from our trading strategy list. The strategies are an excellent resource to help you how to get trading ideas.
The strategies also come with logic in plain English (plain English is for Python traders).
For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
Event-driven strategies – ending comment
If you want to delve into event-driven strategies by all means make sure you backtest your idea before you commit any capital. Also, please keep in the back of your mind that most of the news is simply irrelevant and completely random.
FAQ:
– What types of events are targeted in event-driven strategies?
Events targeted in event-driven strategies include corporate events like bankruptcy, mergers, acquisitions, hostile takeovers, corporate restructurings, spinoffs, and news events like the monthly Jobs report.
– How does an investor take advantage of pricing inefficiencies in event-driven strategies?
Investors attempt to take advantage of temporary stock mispricing before or after corporate events by analyzing the impact of such events on stock prices. They seek to profit from the mispricing that occurs during a period of change.
– Who typically uses event-driven strategies?
Event-driven strategies are mostly used by private equity or hedge funds that have the necessary expertise to analyze corporate events for successful execution. These funds employ specialists to assess the impact of events on stock prices.