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Merger arbitrage is the business of trading stocks in companies that are subject to takeovers or mergers. Arbitrage exploits the fact that takeovers normally involve a big price premium for the company. So long as there is a price gap, there is potential for sizable rewards. But betting on mergers can be risky business. As a general rule, it's a tool that's exclusively for professionals, and probably not something you want to try at home.
Arbitrage involves purchasing an asset at one price for an immediate sale at a higher price. Thus an arbitrageur - a fancy term for the person who buys the stock at the lower price - tries to profit from the price discrepancy. It is fairly rare to find potential opportunities for arbitrage in an efficient market, but once in a while, these opportunities do pop up.
Merger arbitrage (also known as "merge-arb") calls for trading the stocks of companies engaged in mergers and takeovers. When the terms of a potential merger become public, an arbitrageur will go long, or buy shares of the target company, which in most cases trade below the acquisition price. At the same time, the arbitrageur will short sell the acquiring company by borrowing shares with the hope of repaying them later with lower cost shares.
If all goes as planned, the target company's stock price should eventually rise to reflect the agreed per-share acquisition price, and the acquirer's price should fall to reflect what it is paying for the deal. The wider the gap, or spread, between the current trading prices and their prices valued by the acquisition terms, the better the arbitrageur's potential returns. (For related reading, see Trading The Odds With Arbitrage.)