Pre-arbing is the action of investing in merger arbitrage based upon a rumor. The trade involves taking a position in a potential target stock before a deal is announced. Pre-arbing is the name given to the intermediate stage of investment. Sitting after pure speculation as to whether or not a deal will materialize, but before any definitive agreement. Each of these particular strategies have their own merits. They require different skill sets and requires inputs and analysis distinct from alternative strategies. However, the main point here is that they are different. Speculating on takeovers, pre-arbing or merger arbitrage should not be confused.
It is irrelevant whether any subsequent deal announcement is hostile or friendly. Although the attitude of management will affect the level of increase in the stock price following any announcement of a deal. A friendly takeover will see the stock price approach the offer price far quicker than a hostile takeover.
Pre-arbing should not be confused with insider trading. Insider trading is an illegal activity where trades are made based on material non-public information. Pre-arbing is simply a form of speculation, the premise of which if often born out of mosaic theory. That is, the collection and interpretation of public information to arrive at a conclusion similar to the (unknown or unconfirmed) material non-public information.
Pre-arbing Outcomes
This type of speculation can have a huge pay-off as a larger part of the stock movement is captured. As rumors begin to swirl, the value of the target stock increases so the earlier this trade is initiated the more profitable it will be. Likewise, the risks are significantly greater as a deal may never materialize and the stock could fall in value. The risk that an official offer may never materialize is often highlighted in initial SEC filings by the target company. However, should no offer emerge, the downside will not be of the same magnitude experienced in a traditional merger arbitrage investment strategy where the usual entry point is at a much higher price. In this instance, the floor price will also be easier to calculate thus making the risk reward payoff analysis more accurate.
