Humana and Aetna Merge to Challenge UnitedHealthcare
The annualized return is probably about right
In this interest rate environment, a 12.2% annualized return is probably about as good as you’re going to get. It means there’s a lot of risk to this transaction. As discussed earlier in this series, the risk-to-reward ratio appears to be something like 1.3:1, which in normal circumstances is a no-brainer. However, that risk-to-reward ratio is understated due to the possibility of UnitedHealth (UNH) coming in to take over Aetna (AET), leaving Humana (HUM) by itself at the altar.
How do you trade deals like this?
Generally speaking, arbitrageurs aren’t going to win big in deals like this, where there’s so much risk. Arbs make their money by avoiding the minefields, not charging into them. That said, the returns are so good, it may make sense to have a position and trade it around.
This deal will be subject to all sorts of headlines, which will affect the spread. If President Obama expresses skepticism about the transaction, the spread will blow out as arbitrageurs cut their positions. In these situations, you can add to the position on “scares” and then scale out as people come to their senses. There isn’t going to be a definitive “yes” or “no” on this deal for a long, long time. You can make a decent return trading around the position by keeping your head while everyone else is losing theirs.
The key will be position sizing
The art of risk arbitrage is position sizing. For this deal you will probably not want to have a big position since the daily volatility will drive you nuts. A small core position with a trading position is probably the way to go here. If someone comes in for Humana, you can always get bigger.
Other merger arbitrage resources
Other important merger spreads include the Hospira–Pfizer deal. The Hospira (HSP) and Pfizer (PFE) merger is set to close in 2H15. For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.
Investors interested in trading in the healthcare sector should look at the Health Care Select Sector SPDR Fund (XLV).
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