How Company Mergers Create Arbitrage Opportunities for Day Traders - dummies

How Company Mergers Create Arbitrage Opportunities for Day Traders

Every day, companies get bought and sold, and that creates arbitrage opportunities for the day trader in the stock market. In fact, one of the better-known arbitrage strategies out there is merger arbitrage, in which traders try to profit from the change in stock prices after a merger has been announced. This kind of trade starts with the trader looking at the following details in the merger announcement:

  • The name of the acquiring company

  • The name of the company being taken over (and no matter what PR people say, there are no mergers of equals)

  • The price of the transaction

  • The currency (cash, stock, debt)

  • The date the merger is expected to close

Until the date that the merger actually closes, which may be different from the date in the merger announcement, any and every one of the announced details can change.

The acquiring company may learn new information about the target company and change its mind. A third company may jump in and make an offer for more money. The shareholders may agree to support the deal only if they get cash instead of stock.

All that drama creates opportunity, both for traders looking for one-day opportunities and for those willing to hold a position until the merger closing date.

Here’s an example. Say that Major Bancorp offers to buy Downtown Bank for $50 per share in cash. Major Bancorp’s shares will probably fall in price because its shareholders will be concerned that the merger will be a lot of trouble. Downtown Bank’s shares will go up in price, but not all the way to $50, because its shareholders understand the risk that the deal won’t go through.

An arbitrageur would short Major Bancorp and buy Downtown Bank to profit from the concerns. If Overseas Banque decides to step in, the trader may think it a profitable idea to buy Major Bancorp and short Overseas Banque. (If another bidder steps in and places a higher offer for Downtown Bank, then the whole arbitrage unravels — hence, the risk.)