Active arbitrage is a type of trading strategy associated with merger arbitrage. It involves the continuous buying and selling of the target stock as the deal progresses towards completion. In contrast to a plain vanilla merger arbitrage strategy, the active arb is not primarily dependent on the deal closing immediately. Rather, an extended completion timeframe gives more opportunity for trading and therefore potential opportunities for profit. A deal, which has an uncertain expected closing date is often one which has regulatory issues or is a hostile takeover.
Should the deal close sooner rather than later, the trader will still benefit from holding a long position. However, this position may be smaller than the traditional plain vanilla position as the trader may have recently taken some profits. The flip side of this of course is the reduced risk by lowering the stock position. In a higher risk situation, this would seem prudent whilst also allowing the trader the financial flexibility to repurchase additional stock should the price decline. If this is the case, as opposed to the traditional strategy, losses would be reduced.
The major risk in an active arbitrage is a decline in the spread that causes the trader to continuously buy the stock as it drops in value. As the position gets larger, the losses will become larger at an ever-increasing rate. It is necessary therefore to apply a fundamental overlay to this strategy and not rely solely on quantitative analysis. If there is a genuine concern regulatory issues may be a problem, it would be prudent to restrict stock purchases in a declining market. It is imperative traders stay abreast of all deal news associated with the trade.
Active Arbitrage Example
Merger Arbitrage Limited operates as many positions as permitted by market forces using this strategy. If a candidate is suitable, the stock is traded accordingly. At the time of writing, the most prominent stock for the active arbitrage is strategy is Red Robin Gourmet Burgers (RRGB). This takeover has all the characteristics noted above providing numerous opportunities for trading.
Because the proposed takeover is a hostile bid, there is no fixed deal completion date so the active arbitrage strategy is ongoing. This scenario, involves the appearance of almost random news items causing the spread to have greater volatility than a friendly takeover.
Additional Resources
There are many more facets to understanding and trading an active arbitrage strategy. To help traders understand the quantitative side of the strategy we recommend “Quantitative Trading: How to Build Your Own Algorithmic Trading Business” by Ernie Chan. This provides a unique an honest insight into this side of the business as well as additional strategies the trader may not have previously considered.
