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Trading Techniques: Modified Dutch Auction Tender Offer

Trading Techniques: Modified Dutch Auction Tender Offer
April 24
21:11 2012

Significant business events, while important to fundamental traders, can also produce consistent stock price patterns. The modified Dutch auction tender offer is one such event.

A standard Dutch auction takes place as an alternative form of initial public offering (IPO). Google, for example, used this method for its IPO. The company will invite bids for its stock from investors, who propose how many shares they will buy at what price. Once bidding ends, the IPO’s underwriters analyze the bids and determine the final IPO price.

The modified Dutch auction tender offer is the opposite case, in which a company proposes to buy back some of its shares from investors. While this can certainly be accomplished in the secondary market (and usually is), the Dutch auction tender offer is used to make a statement. The company may want to make clear that it feels its stock is undervalued, that it wishes to reduce the float (shares outstanding), or that it wants to return cash to stockholders either without or in addition to a regular dividend. For that reason, the range of the tender offer is normally well above the current share price. The company will announce a price range for the buyback, the number of shares it will purchase, and the duration of the Dutch auction. Current stockholders will then submit bids to sell their shares at a proposed price.

Obviously, you cannot participate in a modified Dutch auction if you are not already a shareholder in the company. However, the stock price should make a predictable move once the auction ends—and that is what this trading technique exploits.

The first consideration is the size of the buyback. The magic number is 17%: if the company is proposing to buy at least 17% of its float, this is a “large buyback.” If the tender offer is for less than17% of the float, that is a “small buyback.” Large-buyback stocks tend to decline more strongly after the auction ends than small-buyback stocks, but in two-thirds of these cases, the stock will close below the tender price the day after the auction ends, and a full 96% will fall an average of 10% below the tender price within the following 90 days.

In order to determine exactly how to play the stock, look at the price range during the auction period. Calculate the difference between the highest intraday high and the lowest intraday low to find the range. Take the range and multiply it by 0.63, then add that to the auction period peak to determine the upward break price target. Take the range and multiply it by 0.48, then add that to the auction period low to determine the downward break target.

The breakout is signaled when the stock exceeds either its auction period high or low. Once that occurs, you may take a long position for an upward break or a short position for a downward break, exiting at the target price you previously determined.

Downward breakouts will typically rebound in a V shape, with an average recovery of 52%. Should your stock break down, you can make two successive plays by shorting, exiting at your target price, and then taking an immediate long position to await the rebound. Upward breakouts tend to be longer-term trends, but if you are focused on short-term trading, you will probably prefer to exit your position once you achieve your target price and move on to another trade.

The final word concerns violated patterns. This occurs when a breakout abruptly reverses, usually within 10% of the breakout point. Such pattern violations signal a strong trend, so you should immediately exit your original position and trade in the new direction—you will probably recover your losses and still achieve a profit.

Always remember that short-term trading requires discipline to be successful. Don’t let greed tempt you into remaining in a position too long, or you may find yourself losing all of your gains and more.

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