In a merger arbitrage setting, reverse Arbitrage is a strategy variant that involves shorting the target stock in order to profit from a decline in the stock value, or equivalently, a widening of the spread. This strategy has been previously referred to as “Chinesing”, a term which has now dropped out of popular use. Reverse arbitrage has two distinct approaches as discussed in the next section.
Reverse Arbitrage Application and Risk
At any point during the process of the deal the arbitrageur may decide the spread is too narrow for a given reason. For example, when the Fitbit (FIT) deal with Google was announced the spread narrowed but it became clear the market had not anticipated a regulatory investigation oven data privacy concerns. Many traders took this opportunity to short the stock reasoning that the current deal closing probability (DCP) too high and subsequently profited handsomely when the stock declined. At this point, it was not necessary for the traders to suggest the deal will break to make a profit, just that the stock would decline if an investigation materialized. This could be viewed as a short term strategy as traders would look to cover the short position once their investment hypothesis has played out. This may occur long before and deal resolution is enacted.
Alternatively, traders may take a longer term view and position themselves to profit should a deal break. This can bring huge rewards if the trader is correct. Upon cancellation of a deal, the target stock will drop to the floor price as dynamically calculated by the trader. In fact, the stock usually drops beyond this point as short term liquidity is effected by many arbitrageurs rushing for the same exit.
The first risk in reverse arbitrage is that the price stagnates and the trader continues to pay short stock borrowing fees. For stocks that are difficult to borrow, such as illiquid stocks, these charges could be extremely high and render the trade unprofitable. Should the deal close before the trader covers the positon, a loss will be recorded equal to the final offer price minus the short sale price. However, the biggest risk comes if a higher bid is announced especially if this forms part of a bidding war. The trader will most likely be left with a substantial loss depending on how quickly they can exit the position.
Further Reading
There have been a number of academic papers that have referred to this topic along with a number of books.
