DFS and COF Deal: Short Positions, Deal Spread, and Risk/Reward Assessment

The Discover Financial (DFS) and Capital One (COF) stock deal has caused short positions in COF to double, reflecting typical arbitrage strategies. These short positions correlate with the widening deal spread.

The dynamics of long and short positions in deal stocks differ from those of other stocks.

Event investors short stocks to capitalize on deals, not necessarily due to bearish sentiment.

The graph illustrates that the short position in COF doubles upon the announcement of the DFS/COF deal, which is a stock deal requiring arbitrageurs to short COF instead of buying it.

The size of the short position (in orange) correlates closely with the deal spread (in blue). This pattern may hold in some deals but not in all, as there are many factors which determine the deal spread.

A wider deal spread indicates increased demand for shorting, however this needs to be balanced with anti-trust issues, the volatility of the stock, borrow costa and availability, the duration of the deal. The deal spread is an important factor but just one of many.

Once the deal closes, the short position will likely collapse; prior to the deal, it was approximately 1.7%.

The long position is reflected in the days to liquidate for DFS, which increased from 15 to 60.

This measure of days to liquidate can be utilized to assess the downside risk in the deal, aiding in the determination of risk/reward.

The deal is not expected to close until mid-next year.

DFS is held 10% by hedge fund managers.

Following the announcement of the deal, the stock rose 12.6%, while the parent company has increased by 9% since then, providing a basis for estimating downside risk.

The Discover/Capital One deal shows how shorting can be related to the deal spread. The short position and deal spread dynamics offer insights into risk and reward as this deal progresses.

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