What is merger arbitrage?
In one line: Merger arbitrage is buying the stock of a company being acquired, below the deal price, to collect the gap if the deal closes as planned.
A simple example
Big Co announces it will buy Small Co for $50 a share in cash. The deal should close in about six months.
Small Co jumps, but only to $48. Not all the way to $50. Why? Because the deal might not happen.
- If the deal closes: you get $50. Gain = $50 − $48 = $2 a share.
- If the deal breaks: Small Co might fall back toward its old price, say $35. Loss = $48 − $35 = $13 a share.
That $2 gap is the "deal spread." A math example, not a promise.
Why it matters
Look at the shape: small possible gain, big possible loss. It's a Risk-reward ratio of about 2 to 13. The trade only makes sense if the chance of the deal closing is very high.
The risk-reward calculator and expectancy calculator let you test that math with your own odds.
What can break a deal:
- Regulators block it, for example over competition worries.
- Shareholders vote it down.
- Financing falls apart, or the buyer walks away.
The wider the spread, the more doubt the market has about the deal.
A common mistake
Thinking it's "free money" because the price is known. The deal price is known only if the deal closes. When deals break, the target can fall far below where it traded before. A run of small gains can be wiped out by one break.
There's a time cost too. A $2 gain that takes 18 months instead of 6 is a much smaller yearly return.
Size it from the break price, not the deal price. Your real stop is where the stock would go if the deal fails.
Questions
Is merger arbitrage risk-free?
No. The main risk is the deal falling through, which can cause a sharp drop.
Why doesn't the stock trade at the full deal price?
Because of the chance the deal fails, and because your money is tied up until it closes.
What is a stock-for-stock merger?
The buyer pays in its own shares instead of cash. Then the spread depends on both stock prices, which makes it more complex.
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