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PYPL and EBAY stocks are expected to start trading in the “when-issued” market this week. Introducing four investment strategies for different levels of risk tolerance. The PayPal spin-off investment scenario reflects an expected return of 2% to 11%. The long waiting period is finally coming to an end as PayPal (Pending: PYPL ) and eBay (NASDAQ: EBAY ) are getting closer to the first spin-off milestone – July 8th, the spin-off record date. The record date has some significant meanings in this context: Holders of EBAY shares will be entitled to receive PYPL at the distribution. The first batch of (largest) shareholders will receive their distributed shares. Trading at the “when-issued” market begins based on shares distributed in the first batch. After the previous article published about the PayPal spin-off arb strategy, I received many questions about how to create an optimized position that would benefit from this spin-off arb opportunity in a hedged environment. I answered some of this questions, and I want to present some scenarios that will assist readers and potential investors to tailor the best position to meet their unique characteristics. At the beginning, I wish to address two primary issues that are fundamental to this investment strategy: risk aversion and outflow theory. Before investing in the PayPal spin-off (if investing at all), investors should know exactly what their risk appetite is. Some investors take high risks in anticipation of higher returns than usual, and other investors take small risks and expect moderate gains. Both approaches are perfectly fine, but an individual investor should think of that before engaging with a spin-off arbitrage strategy and create an investment strategy that fits his or her risk aversion preferences (institutional investors assess their risk appetite regularly). Investors looking to gain from a short-long position should accept the outflow theory that I presented in a May article . An investor who believes that both eBay and PayPal will soar after the split should engage in a different strategy, which I will not cover here, and hold both equities long. To create a trading scenario for the spin-off, I will assume that most readers will receive the distributed shares between a week after the record date and the distribution date. At this point, EBAY.wi and PYPL.wi shares already reflect a 10% price fluctuation. Let’s discuss the four possible scenarios: Scenario A: take no action during the spin-off; Scenario B: hold only long position (sell 100% EBAY); Scenario C: hold long and short positions at a 2:1 ratio (sell 50% EBAY); Scenario D: hold long and short position of the same size. I also assume that the PYPL.wi price will increase by 5% during the period I described above, 3% during the weekend between the distribution date and PYPL’s first trading day, and an additional 10% on the first trading day. All figures are within the reasonable spin-off fluctuations that were presented in the previous article. I also assume that the positive changes in PayPal’s stock price equal the adverse changes in eBay’s stock price. I calculated the return and volatility based on a distributed share price of $32 for a PayPal share and $28 for an eBay share, assuming cash from selling the EBAY stock was not reinvested. The four scenarios presented above yielded the following return and volatility figures: Scenario A B C D Return 2.1% 7.1% 9.0% 10.9% Volatility 1.05% 2.80% 3.39% 4.01% Investors highly averse to risk can choose to take action and get an estimated return of 2% of scenario A or just sell all units of the EBAY stock once received and gain 7% from a PYPL long-only position as presented in scenario B in the period between the moment the distributed shares are received until the end of the first day of trading in PYPL shares. Investors who have some tolerance for risk can choose a long-short strategy that maximizes return from the spin-off but is accompanied with a slightly higher risk. Scenario C, which suggests to sell 50% of eBay’s distributed shares and short the other 50%, offers a lower risk for investors than scenario D. Investors who are somewhere in the middle between complete risk aversion and total risk taking could choose a larger/smaller quantity of EBAY shares to sell in order to hedge PYPL fluctuations. Investors who hold options of eBay pre-distribution can add an additional hedging layer with post-distribution options and protect their positions better from any downside. However, since the outflow of cash that is expected from PYPL and EBAY will trigger a possible movement in prices, it might be easier to hedge the position by playing with the ratio between the long and short positions. Disclosure: I am/we are long EBAY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information provided in this article is for informational purposes only and should not be regarded as investment advice or a recommendation regarding any particular security or course of action. This information is the writer’s opinion about the companies mentioned in the article. Investors should conduct their due diligence and consult with a registered financial adviser before making any investment decision. Lior Ronen and Finro are not registered financial advisers and shall not have any liability for any damages of any kind whatsoever relating to this material. By accepting this material, you acknowledge, understand and accept the foregoing. Scalper1 News
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