Investoid

Some traders look for ‘high probability’ trades, based on mathematical assumptions about how stocks behave. Others look for arbitrage opportunities or other systematic deficiencies that can lead to a guaranteed (or nearly guaranteed) profit. One of the opportunities I find that presents a high probability and highly profitable trade is index changes.

Once in awhile, major indices will change the complement of stocks in their basket. Sometimes this is due to some companies going private, other times it is because a company has outgrown an index’s stated target (eg. a small cap index). In yet other instances a company is failing to meet listing requirements or is otherwise being halted from trading. Whatever the reason, when a company is added or dropped to an index it is a good trading opportunity.

Why? Because in today’s passive investing world, there are trillions of dollars dedicated to tracking various indices. This means that when a company is added to an index, index fund managers are obligated to purchase the stock reasonably quickly, or else their fund’s performance will begin to materially deviate from the underlying index. Furthermore, many actively managed funds are closet index funds, meaning they want to ensure they typically purchase the companies in an index to ensure they do not underperform their benchmarks.

This adds up to a lot of buyers chasing a relatively small amount of sellers. The Vanguard S&P 500 Index alone has $175 billion under management. Even if a new company takes up only 1/2000th of that index, that means the fund must purchase $87.5 million worth of stock in a company that probably has a market cap of about $10 billion, which represents nearly 1% of the company’s total shares outstanding. And that’s just for one fund, albeit the biggest. The opposite effect is true for companies that are dropped from indices. The larger the index (and the more followed it is), the greater the effect.

As a result, you typically see a sustained run in a company’s stock for anywhere from a few days to a few weeks. It is especially astute when the announcement occurs prior to the actual change: despite the fact that the stock will jump on the news, the true increase in price will only occur once the change happens and fund managers begin to buy the stock.

One recent example of this phenomena is Expedia (EXPE: Nasdaq). It was announced on Sept 24 that the stock would be added to the S&P 500 on Oct 1. The stock jumped about 5% on the news, but settled around that figure for the next several days. Since Sept 28 (the last trading day before Oct 1), the stock is up another 9.9%.

I played this news by buying a slightly in the money call option. I purchased the Nov $30 call option on Sept 26 for $3.20, and sold it on Oct 2 for $3.90, yielding a 22% gain (not including commissions). While I could have held on for hopes of higher gains (the option is now worth $4.90), but I had hit my target profit and needed to follow my strategy rules.

I have yet to find a specific site or news source that will let me know of upcoming changes to indices, so if anyone out there knows, feel free to leave a comment.