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)