How to make money through risk arbitrage trading

Interested in profiting from stock transactions that have made headlines in M&A news? Risk arbitrage may be the way to go.

Risk arbitrage is also called M&A arbitrage trading, which is an event-driven speculative trading strategy. It attempts to generate profits by holding a long position in the target company’s stock and optionally combining it with a short position in the acquired company’s stock to create a hedge.

Risk arbitrage is an advanced trading strategy, usually implemented by hedge funds and quantitative experts. It can be practiced by individual traders, but since this strategy involves high risks and uncertainties, it is recommended for experienced traders.

This article uses a detailed example to explain the working principle of risk arbitrage trading, risk return profile, possible scenarios of risk arbitrage opportunities, and how traders can benefit from risk arbitrage.

Key points

  • Risk arbitrage is an event-driven speculative trading strategy that attempts to generate profits by holding a long position in the target company’s stock.
  • Risk arbitrage can also combine this long position with the short position of the acquired company’s stock to form a hedge.
  • As this strategy involves high risks and uncertainties, it is recommended that experienced traders carry out risk arbitrage.

How risk arbitrage trading works

Suppose a hypothetical company TheTarget, Inc. closed at $30 per share last night, after which TheBigAcquirer, Inc. publicly offered to purchase it at a premium of 20% ($36 per share). The news is immediately reflected in TheTarget’s morning opening price, and its stock price will reach around $36.

There is always transaction risk in mergers and acquisitions (M&A) transactions. The transaction may not be completed due to a variety of reasons: regulatory challenges, political issues, economic development, or the target company’s refusal of the offer (or counter-offers from other bidders). Therefore, the price of TheTarget will hover below the price of 36 US dollars, such as 33 US dollars, 34 US dollars, 35.50 US dollars and so on. The closer it is to the offer price, the more likely it is that the transaction will pass.

The transaction price may also be higher than the quoted price of $36. This happens when there are multiple interested acquirers and some other bidders are likely to make higher bids. However, the price may stabilize slightly below the final highest bid level. So let’s continue with the previous situation: the transaction price is less than $36.

Suppose the price of TheTarget starts to rise from $30 to an offer price of $36. Risk arbitrage traders seized the opportunity to buy stocks at a price of $33. After completing all mandatory regulatory procedures within three months, the transaction was finally completed at a price of $36. Traders earn $3 per share, or 9.09% in three months, or about 37% in annualized earnings.

Hedging the acquisition of company stock

In reality, as the price of TheTarget company rises, the share price of TheBigAcquirer company is usually observed to fall. The reason is that the acquiring company will bear the costs of financing the acquisition, paying a premium, and enabling the target company to integrate into a larger unit. In essence, the goal is at the expense of the acquirer’s interests.

For example, if TheBigAcquirer’s stock price drops from $50 to $48 after making this bid, the trader can open a short position at $49. Earnings per share are $1, and earnings within three months are 2%, that is, the annualized earnings are about 8%.

Adding the profits of long and short trades will result in (3+1)/(33+49) = 4.87%-or 19.51% of annualized profits in three months.

Other trading scenarios for risk arbitrage

In addition to mergers and acquisitions, other risk arbitrage opportunities also exist between the two companies in the case of divestment, asset divestiture, new share issuance (rights issue or stock split), bankruptcy application, distress sale or stock swap.

In this case, risk arbitrageurs are usually at an advantage because they provide sufficient liquidity to trade related stocks in the market. They buy things that other ordinary investors are eager to sell, and vice versa. Experienced risk arbitrageurs usually manage to obtain a premium on such transactions to provide much-needed liquidity.

This kind of company-level change or transaction takes enough time to achieve, spanning months, quarters, or even more than a year. This can provide opportunities for expert traders who may trade and profit multiple times on the same stock.

The risks of arbitrage trading

Risk arbitrage provides high profit potential. However, the degree of risk is also proportional. The following are some risk scenarios that may be caused by trade operations and other factors.

Difficulty tracking

M&A and other corporate developments are difficult to track on a regular basis. The efficient market hypothesis is largely applicable to real transactions, and the impact of news or rumors about possible mergers and acquisitions is immediately reflected in stock prices. Traders may eventually open positions at unfavorable and extreme price levels, with little room for profit. Brokerage fees have also eroded profits.

Transaction risk

Transaction risk refers to the possibility of transaction failure. Trading risks have multiple impacts, and risk arbitrage traders need to assess truthfully. This may even involve consulting legal experts, which can increase costs.

If the transaction fails, the price will return to its original level: $30 for the target company and $50 for the acquirer. The trader will lose $3 and $1, resulting in a loss of $4. Calculated as a percentage, ($3+$1)/($33+$49) = 4.87% in 3 months, or 19.51% of the annualized total loss.

Overvalued premium

Acquirers/bidders often overestimate premiums, causing their stock prices to fall. When the deal fails, the market cheers for the acquirer to avoid a bad deal, and its stock price then rises, possibly even higher than its previous level. For traders who lack the stock of the acquirer, this may lead to increased losses.

Stock price drop

The same transaction failure has a negative impact on the target stock price. Its price may fall far below the level of the pre-trade period, resulting in further losses.

Uncertain timetable

Uncertain timetables are another risk factor for event-driven company-level transactions. Transaction funds are locked in the transaction for at least a few months, leading to opportunity costs. Some traders also try to profit by using derivatives to enter complex positions. However, derivatives have an expiry date, which may become a challenge during the long period of transaction confirmation.

Leverage

Risk arbitrage transactions are usually carried out using leverage, which greatly magnifies the potential gains and losses.

Bottom line

The world of mergers and acquisitions is full of uncertainty, but for experienced traders who are proficient in capital management and able to act quickly and effectively on real-world development, risk arbitrage may be a highly profitable strategy.

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