Getting an overnight pop of 30% or 40% in a stock you own when a takeover bid for it is announced is a heady feeling indeed. But be warned – benefiting from mergers and acquisitions is easier said than done. The prospect of making windfall profits from a potential M&A deal is so tempting that numerous people have paid huge fines or even gone to jail for engaging in illegal insider trading in stocks that are acquisition targets.

The most common tactic to profit from M&A activity is through merger arbitrage, which involves taking a long position in shares of the target company and a simultaneous short position in shares of the acquiring company, once a takeover bid is announced.

Merger arbitrage seeks to profit from (a) the differential or spread between the price offered for a target stock and its current trading price, and (b) the decline often witnessed in an acquirer’s stock price (which could be for various reasons such as the acquirer paying too much for the target, taking on too much debt to fund the purchase, lack of synergies etc.).

If things go according to plan, as the deal nears completion, the investor profits from closing of the spread between the takeover offer and the target’s current trading price (on the long position), and the decline in the acquirer’s stock price (on the short position). Generally, the bigger the spread between the target’s stock price and the price offered by the acquirer, the higher the potential return from the merger arbitrage. (Related: Biggest M&A Disasters.)

Although merger arbitrage hedges market risk to a significant extent by offsetting a long position in one stock with a short position in another, the strategy carries its own risks. For example, in severe bear markets, shares of the acquirer and target may both decline, because investors may be pessimistic about the combined entity’s long-term prospects or about the possibility of the deal going through. Merger arbitrage also requires a significant amount of capital for relatively low returns.

Merger arbitrage also does not give an investor the opportunity to benefit from the stock surge when a deal is first announced. For this, an investor has to be attuned to the M&A market, and be in the know about which sectors in general have significant takeover activity, and which stocks in those sectors are possible takeover targets. Occasionally, clues about an impending takeover can be found in the public domain, in the form of unusual trading volume, a surge in volume of options traded, and “chatter” on message boards.  

A trader can even attempt to profit from an M&A deal after it closes. For example, if the acquirer paid too much for the target and is now saddled with debt, the trader can take a short position in the stock of the acquirer or buy puts on it in expectation of a significant price decline. Conversely, a long position can be initiated in the acquirer if the trader thinks that the target acquisition will contribute to better financial results than currently estimated by market participants.

The Bottom Line

Making consistent profits from M&A activity is no easy task. While efforts to identify M&A candidates may occasionally be successful, it should be stressed that buying a stock or stocks purely on merger speculation is not a viable investment strategy over the long term.