Trevor Dale, CFA discusses one hedge fund strategy called merger arbitrage.

This is what the name would have you assume, it is a strategy around mergers. Further it is trying to take advantage of the pricing discrepancies within the merger, called arbitrage.

Essentially this is when one company tries to buy another company.

This strategy would involve buying the company being acquired and shorting the company doing the acquiring.

Usually the company being bought will be bought at a premium to the price prior to the news being announced.

As a result of spending money and often diluting the stock, the acquirer’s stock price will fall usually.

Therefore if you can own the stock that goes up in value and bet against the stock price that falls then there is a profit to be made.

The strategy becomes very smart in that in an all stock deal they will buy the target company and short the appropriate amount of acquirer stock so that when the deal goes through they are left with no stock at all and just the cash profit.

Then because there is little market exposure they can leverage up the strategy and move on to the next one.

This leverage amplifies both gains and losses.

The advantage in this strategy is that it is fairly market neutral and doesn’t swing as much with the overall market as there is a long/short strategy at play.

The risk is that the deal could fall through and prices move in the opposite direction than anticipated.

Also due to the leverage, this will enhance losses but also any gains.

The overall economy also affects this as the busier the market is with mergers and acquisitions, the more trades there are to utilize inside this strategy.

One thing I didn’t mention is that when using this strategy is speed is critical. The faster someone can get into a trade, the better price they usually get, before the market realizes more of the price.

My question to you is what is the one thing that you’re taking away from this information?

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Please note this is not meant as individual advice and is delivered for educational purposes only. We recommend you seek the help of a licensed professional prior to taking any action.