DEFINITION of Rumortrage
Rumortrage is a trading strategy to take advantage of price discrepancies of two stocks in a mergers and acquisition (M&A) scenario that have resulted from a market rumor. A combination of "rumor" and "arbitrage," rumortrage involves quick decision-making with respect to going long and short securities that are subject to some sort of speculation making its rounds in the market. Rumortrage trades, to be profitable, must be executed before the price discrepancies are "arbitraged" away.
BREAKING DOWN Rumortrage
From time to time an M&A deal rumor will present an opportunity to profit from the deviation in the market prices of assets from the fair prices of the same assets. The normalization of the temporary price discrepancy, if the rumor turns out to be true, represents the trading opportunity. For example, suppose a rumor emerges that High Tech Company A is imminently going to bid $120 per share for High Tech Company B in an all-stock deal. The deal valuation, at $120 per share, is considered dilutive to Company A and quite generous for Company B. Traders acting on this rumor may decide to short Company A stock and go long Company B stock. Further assume that the fair value of Company B is $110 per share, less than what Company A is rumored to be prepared to pay. Active arbitrage trading in Company B stock will bring the market price toward $110 per share, while the stock price of Company A will progress toward a reflection of the stock deal exchange ratio. If the rumor turns into reality, the short and long trades will be profitable, with more trading returns to those who acted early in the life of the rumor.
However, if the rumor is false, which can often be the case, the trade set-ups will backfire and leave traders with losses. Other considerations that may factor into the volatility or price range of rumortrage trading are the odds that the hypothetical deal could actually close, whether another bidder could emerge, or whether payment terms (e.g., all-stock to cash plus stock) could change.