I had earlier posted about a trade that was carried out in Britannia industries where the company issued bonus debuntures and the markets mispriced the stock post the record date giving reasonable returns in the time frame that the trade was carried out. The link to the post is enclosed below.
I had a round of email exchanges with a friend whose bone of contention or query was
How do u that the market will misprice when u initiate the trade? Is it just experience or a element of probability or pure luck?.
I am attaching the email response that I had sent him …
The starting point in a trade like this is to ensure
1) The market risk is very low which is to time the trade very close to the actual event date or the record date.
2) More importantly - valuation comfort. If everything else goes wrong are u still comfortable holding the stock from a valuation standpoint.
Without valuation comfort the trade is a strict No go.
Lets look at the markets are irrational part. True markets do turn irrational at times but i want to inverse that statement. Markets are not rational all the times which is not saying that they are irrational but they take time to reach a level of rationality. I dont know whether I am able to spell out the subtle difference by inversing that statement. The time that market takes to attain that rationality is the time window that a arbitrageur gets for the trade.
So it comes both from experience/ insight and probability. The market has diff kinds of participants day traders, arbitrageurs, tech analysts, long term investors who look individually look at diff information points so at a given point a participant would not have not digested all the news points. For ex If i am buying a stock from a long term objective i might not have look at the technicals ( i anyway dont believe in technicals) and vice versa. So not all participants would have digested a particular corporate action. If it is a bonus or a dividend then most participants would digest it but other corporate actions which have a element of complexity dont get digested as fast.
This is more true in the midcap/ small cap segment which is under researched and uder tracked. If HLL had done a similar exercise i would doubt the arbitrage window would have existed.
It isnt risk free by any stretch of imagination. Its just about how much risk can u eliminate and dont get into a situation of picking pennies in front of a roadroller.
Trust that could add some value.
PS: Remembered a interesting exchange from Alice in Wonderland
Alice: But I don't want to go among mad people.
The Cat: Oh, you can't help that. We're all mad here. I'm mad. You're mad.
Alice: How do you know I'm mad?
The Cat: You must be. Or you wouldn't have come here.
Alice: And how do you know that you're mad?
The Cat: To begin with, a dog's not mad. You grant that?
Alice: I suppose so,
The Cat: Well, then, you see, a dog growls when it's angry, and wags its tail when it's pleased. Now I growl when I'm pleased, and wag my tail when I'm angry. Therefore I'm mad.