Interested in profiting from trading stocks that are making headlines in mergers and acquisitions news? Risk arbitrage is the way to go.

Also known as merger arbitrage trading, risk arbitrage is an event driven speculative trading strategy. It attempts to generate profits by taking a long position in the stock of a target company and optionally combining it with a short position in the stock of an acquiring company to create a hedge. (Related: Trade Takeover Stocks With Merger Arbitrage)

Risk arbitrage is an advanced-level trade strategy usually practiced by hedge funds and quantitative experts. It can be practiced by individual traders, but is recommended for experienced traders due to the high level of risk and uncertainties involved.

Using a detailed example, this article explains how risk arbitrage trading works, the risk-return profile, likely scenarios for risk arbitrage opportunities and how traders can benefit from risk arbitrage.

Example of Risk Arbitrage Trading

Let's say that TheTarget, Inc. closed at $30 per share yesterday evening, after which TheBigAcquirer, Inc. placed an open offer to buy it at a 20% premium, at $36 per share. This news is reflected instantly in the morning's opening prices of TheTarget, and its shares will reach somewhere around $36.

There is always a deal risk involved in merger and acquisition (M&A) transactions. The deal may not go through for a variety of reasons: regulatory challenges, political issues, economic developments, the target company rejects the offer or receives counter-offers from other bidders. Due to this, the price of TheTarget will hover below the offer price of $36, say at $33, $34, $35.50 and so on. The nearer it is to the offer price, the higher the probability for the deal to go through.

There is also a chance that the trading price may shoot above the offer price of $36. It happens when there are multiple interested acquirers and there is a high probability that some other bidder(s) may place a higher bid. Still, the price would likely settle at a level somewhat lower than the final highest bid. So let's proceed with the former case, of the trading price being at less than $36.

Assume the price of TheTarget starts moving up from $30 towards the offer price of $36. The risk arbitrage trader seizes the opportunity in time to buy the shares at $33. The deal does go through at $36, after all mandatory regulatory processes are completed, in three months' time. The trader earns a profit of $3 per share, or 9.09% in three-months, or roughly 37% annualized profit.

Hedge Acquiring Company Stock

In reality, along with the price jump in TheTarget company, a decline in share price of TheBigAcquirer company is also typically observed. The rationale is that the acquiring company will bear the cost of funding the acquisition, paying the price premium, and enabling the target company to be integrated into the larger unit. In essence, the target benefits at the expense of the acquirer.

If the share price of TheBigAcquirer declines from $50 to $48 after it makes this bid, the trader can take a short position at $49, for instance. It benefits by a $1 profit per share, or 2% in three months, or roughly 8% annualized profits.

Summing up profits from both long and short transactions will lead to (3+1)/(33+49) = 4.87% in three months, or 19.51% annualized profits overall.

Other Trade Scenarios for Risk Arbitrage

Apart from M&A, other risk arbitrage opportunities exist in cases of divestments, divestitures, new stock issuance (rights issue or stock-splits), bankruptcy filings, distress sales, or stock-swap between two companies. 

Risk arbitrageurs are often at an advantage in such situations, as they provide sufficient liquidity in the market for trading the involved stocks. They buy what other, common investors are desperate to sell, and vice versa. Experienced risk arbitrageurs often manage to command a premium in such trades for providing the much-needed liquidity. (Related: Trading The Odds With Arbitrage)

Such corporate level changes or deals take sufficient time to materialize, spanning months, quarters or even more than a year, which provides opportunities to expert traders who may trade and profit multiple times on the same stocks.

Risks in Arbitrage Trading

Risk arbitrage offers high-profit potential, but the risk magnitude is also proportionate. Here are some risk scenarios, which could result from trade operations and other factors:

  • Mergers and acquisitions and other corporate developments are difficult to track regularly. Efficient Market Hypothesis applies to a great extent in real-life trading, and the impact of news or rumors about possible M&A gets instantly reflected in stock prices. Traders may end up taking positions at adverse and extreme price levels, leaving little room for profit. Brokerage charges also eat into profits.
  • Deal risk, which indicates failure of the deal to go through, has multiple repercussions, and risk arbitrage traders need to assess it realistically. This may even involve consulting legal experts, which increases expenses.
  • If the deal fails, prices will revert to original levels - $30 for the target and $50 for the acquirer. The trader will lose $3 and $1, leading to a loss of $4. In percentage terms, ($3+$1)/($33+$49) = 4.87% in three months, or 19.51% annualized loss overall.
  • It often happens that an acquirer/bidder over-prices the premium, and hence its stock price falls. When the deal fails, the market cheers the avoidance of a bad deal for the acquirer, and its stock price then rises, potentially even higher than its earlier levels. This may lead to an increased loss for the trader who is short on acquirer stock.
  • The same scenario of deal failure affects the target stock prices negatively. Its prices may fall to much lower levels than those during the pre-deal period, leading to further losses.
  • The uncertain timeline is another risk factor for trades on event driven corporate level deals. The trading capital is locked in the trade for at least a few months, leading to opportunity cost. A few traders also attempt to benefit by entering complex positions using derivatives. Derivatives, though, come with expiration dates, which may act as a challenge during long periods of deal confirmation.
  • Risk arbitrage trades are usually on leverage, which greatly magnifies the profits and loss potential.

The Bottom Line

The world of mergers and acquisitions is full of uncertainty, but for experienced traders, who are adept in capital management and capable of quickly and effectively acting on real-world developments, risk arbitrage can be a highly profitable strategy.