When Mergers Attack — POT Edition

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  • on August 25th, 2010

Long/Short strategies always run the risk of unanticipated events wreaking havoc on your trades. Pair traders exchange market risk for company specific risk.  One of those risks is merger and acquisition.  The IPI – POT spread in the immediate aftermath of BHP announcing their unsolicited bid for POT is a perfect example of how vicious this risk can be.

Here is the spread trading in “normal” conditions.  The daily volatility of the spread pre-merger is $3.12 and even though it makes big swings, it tended to behave itself.  This was a popular pair to trade because it gave you a lot of bang for your buck.  The companies traded with a high correlation.  Both are potash producers so they have a fundamental reason to trade together.

I can imagine based on this chart there were many traders establishing long positions in the spread looking for the pair to converge back to the mean.  Afterall, the pair had done this many times in the past.

Surprise! On the morning of Tuesday August 17 2010 BHP announced that it was making an unsolicited bid for POT for $130 in an all cash deal.   POT promptly rejected the bid, calling it “grossly inadequate.”  This was later followed up with news that BHP would likely increase their bid.  As you can see from the chart, the spread moved roughly $24 or 12-times its typical daily move.  This is because POT moved aggressively higher and IPI did not.  Side note: it’s very odd that this deal was announced on a Tuesday.  Merger Monday is when most of this deal flow hits the public.

Below is the chart of the spread to present day.  The spread has moved another $18+ since the news was announced.  IPI clearly is not moving in sympathy with POT.  I’m sure there were more than a few traders holding out hope that if they held on to the under water position they could recoup their losses.  Maybe the Canadian government would block the deal?

The moral of the story here is that these news drivers can take on a life of their own.  Even if the BHP POT deal never happens, this spread is forever changed in my opinion and it may never trade at the previous levels.  Hands off.

Note: I was not caught in this particular merger, but I have been involved in a few of these during my career.  They are nasty.  Unfortunately you have to build this type of risk into your business plan and do your best to research the sector so that you don’t get caught in these events.  Best laid plans.  Sometimes you just get blindsided.


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