I probably will need to apologise to the majority of the readers for the simplicity of a couple of the recent posts. The thing is, the readership is growing and more people are asking me to address some of the basics. One of the concepts that some have difficulty with is making money from short positions that don’t have to go down. As we know all too well, the media only mention shorting in the context of profiting when a company drops – and the more it drops, the bigger the profit. That is a meaty story for them, especially if one of those fat cat hedge funds drives a company into oblivion. People in the industry know the majority of short selling is for arbitrage or hedge purposes that suggests an offsetting long position somewhere.
The other day I showed a simple pairs trade. Today I am going to latch on to the current news regarding the Kraft bid for Cadburys. In a simplified stereotypical bid situation, the trader goes long the company being bid on, and short the company doing the bidding. I have included a Bloomberg chart below that plots the relative prices for Cadburys, Kraft, Hershey and Nestle. The latter two are mentioned as among potential bidders. As you can see in the chart, the price of Cadbury has rocketed upwards relative to the other three. Therefore at the headline level, it was a straightforward profit if you traded Long Cadbury, short Kraft. Real life suggests other risks and costs and doesn’t take into account a number of factors that impact the true profitability. The objective here is just to give you an idea of how it works.
A takeover is a bit different situation than the pairs trade in that it is often the case the acquiring company share price does indeed drop as the market considers whether a fair and affordable offer is made. This is especially likely in the event a bidding war emerges. Even so, the point is that the short doesn't have to go down to generate a profit for the trade.
