Merger arbitrage is the business of trading stocks in companies that are involved in takeovers or mergers. The most basic of these trades involves buying shares in the targeted company at a discount to the takeover price to sell them at a higher price when the deal goesꦅ through.

Betting on mergers is a risky business, however. It's a tool that's exclusively for professionals as a rule and it may not be something you want to try at home.

Understanding Basic Merger Arbitrage

Merger arbitrage is also known as "merge-arb." It involves trading the stocks of companies that are engaged in mergers and takeovers. An arbitrageur will go long or buy shares of the target company when the terms of a proposed merger become public. These shares trade below the acquisition price in most cases.

Those investors who already own shares in the target company when the takeover is announced have likely seen big gains already because most acquisition prices are well above the market price. And those investors may not want to wait around until the deal goes through before realizing their gains. It could take many months. This is where the merger arbitrage trader steps in, 澳洲幸运5官方开奖结果体彩网:buying the shares at a discount in exchange for assuming the൩ risk that the deal 𝄹may fail.

The target company's stock price will rise to the agreed acquisition price if the deal does go through. The wider the gap or spread between the current trading prices and their prices v𝐆alued by the acquisition terms, the better🐻 the arbitrageur's potential returns.

A Successful Merger Example

Suppose Delicious Company is trading at $40 per share when Hungry Company comes along and bids $50 per share: a 25% premiu൩m. The stock of Delicious will immediately jump but it will likely soon settle at some price higher than $40 and less than $50 until the takeover deal is approved and closed.

Let's say that the deal is expected to close at $50 and Delicious stock is trading at $47. A risk arbitrageur seizing the price-gap opportunity would purchase Delicious at $48, pay a commission, hold on to the shares, and eventually sell them for the agreed $50 acquisition price when the merger is closed. The arbitrageur pockets a profit of $2 per share or a 4% gain less trading fees from that part of the deal.

澳洲幸运5官方开奖结果体彩网:Mergers and acquisitions take about six to nine months to complete from the time that they're announced. That 4% gain would 🐼therefore translate into a 12% annualized return.

Know the Risks to Avoid the Losses

This sounds fairly straightforward but it's not that simple. Things don't always go as predicted in real life. The entire merger arbitrage business is a risky one in which takeover deals can fizzle and prices can move in unexpected directions, resulting in sizable losses for the arbitrageur.

The biggest factor that increases the risk of participating in a merger arbitrage is the possibility of a deal falling through. Takeovers can be scrapped for numerous reasons including financing problems, due diligence outcomes, personality clashes, regulatory objections, or other factors that might cause the buyers or sellers to pull out. 澳洲幸运5官方开奖结果体彩网:Hostile bids are also more likely to fail than friendly ones. The longer a deal takes to close, the more things can go wrong.

Consider the consequences of the Hungry-Delicious deal falling through. Another company might make a bid for Delicious so its share value may not fall by much. The arbitrageur's position in the target company would probably fall back to the original $40 price, however, if the deal collapses with no alternative bids being offered. The arbitrageur would lose $8 per share or roughly 16% in this case.

More Complicated Merger Arbitrage Scenarios

There are other ways to trade a takeover or merger. The share price of the acquiring company falls many times, perhaps because investors express skepticism about the wisdom of the deal or the company taking on too much debt. An arbitrageur will therefore often 澳洲幸运5官方开奖结果体彩网:short sell the acquiring company by borro🌄wing shares with t♐he hope of repaying them later with lower-cost shares.

The market might interpret the blown deal as a big loss for the acquiring company if the deal falls through and its shares might fall in value. A failed deal might mean that Hungry's stock falls from $100 to $95. The arbitrager would gain $5 per share from short-selling Hungry's stock in this case. Short selling the acquirer's stock would act as a hedge, offering some shelter from the $8-per-share loss suffered on t🐻he target's stock.

A failed deal might be cheered by the market, especially one in which the acquirer has bid an excessively high price. Hungry's share price might return to $100 or it may go even higher to $105. The arbitrager loses $8 per share on the long trade and $5 per share on the short trade in this case for a combined loss of $13.

Risk and Merger Arbitrage

Merge-arb deals are supposed to be fairly safe from broader 澳洲幸运5官方开奖结果体彩网:stock market 澳洲幸运5官方开奖结果体彩网:volatility with 澳洲幸运5官方开奖结果体彩网:short positions offsetting long positions. That's not always the case in practice, however. A 澳洲幸运5官方开奖结果体彩网:bull market can push up the share value of the target company, making iꦛt too pric🔴ey for the acquirer. It can push up the price of the acquirer, creating losses on the short-selling end of the arbitrage deal.

A 澳洲幸运5官方开奖结果体彩网:bear market can create problems as well. Arbitrageurs suffered hefty losses during the 2000-2001 澳洲幸运5官方开奖结果体彩网:market crash. The stock prices of both would have dropped if Delicious and Hungry had been engaged in a takeover deal during that time. Delicious would likely have fallen more than Hungry because Hungry would have withdrawn its offer as market optimism dried up. Their losses would have been even greater if arbitrageurs hadn't 澳洲幸运5官方开奖结果体彩网:hedged by short-selling Hungry stock.

Arbitrageurs mix up traditional moves to offset some of the risk, sometimes shorting acquisition targets and going long the acquirer then selling calls on the target's shares. The seller profits from the price paid for the call if the merger falls apart and the price falls. The call reflects much of the difference between the 澳洲幸运5官方开奖结果体彩网:current price and the 澳洲幸运5官方开奖结果体彩网:closing price if the merger closes successfully.

Expert Business

Small investors who think they might try a bit of merge-arb should probably think again. Veteran arbitrageur Joel Greenblatt recommends that individual investors steer clear of the highly risky merger-arbitrage arena in his book "You Can Be a Stock Market Genius" (first edition: 1985).

The merge-arb business is largely the domain of specialist arbitrage firms and 澳洲幸运5官方开奖结果体彩网:hedge funds. The job for these firms lies in predicting which proposed takeovers will succeed and avoiding those that will fail. This means they must have experienced lawyers at their disposal to evaluate deals as well as securities analysts with an understanding of the real worth of the companies involved.

A diversified collection of bets on announced deals can make steady returns for these firms but a stream of gains is still sometimes punctuated by the occasional loss when a "sure-fire" deal falls apart. These 澳洲幸运5官方开奖结果体彩网:specialist firms can sometimes still get deals wrong even with high-priced professionals to back them 🍃up with information.

The Bottom Line

Merger arbitrage potentially can deliver decent returns if all goes as planned. The problem is that the 澳洲幸运5官方开奖结果体彩网:world of mergers and acquisitions is r𝓀ife with uncertainty. Betting on price movements around takeovers is a very risky business where profits are harder to come by.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.