If you've been investing for some time, odds are that you've heard about arbitrage. Many large financial institutions use arbitrage to make easy money, often at the expense of less sophisticated investors. Small investors, it's implied, can't hope to make money through arbitrage-based strategies.

While it's true that some such strategies require a significant amount of capital, there are other ways to use arbitrage, even if your available resources limit you to relatively small transactions.

How arbitrage works
In general, arbitrage opportunities can exist whenever there are at least two different markets in which a particular good is offered for trade. Unless the prices in each market remain exactly the same at all times, alert investors can exploit any discrepancy in price.

For example, shares of Royal Dutch Shell (NYSE:RDS-B) are traded on the London Stock Exchange, and via American Depositary Receipts (ADRs) on the New York Stock Exchange. Theoretically, the prices of ADRs trading on the NYSE and Shell shares trading on the LSE should be identical -- at least during the hours each day during which both markets are open for trade.

Historically, the lack of instant communication and reliable shipping made arbitrage opportunities common. In modern times, advances in communication and shipping have reduced the number of pure arbitrage opportunities, which involve little or no risk. These days, index arbitrage opportunities on stock exchanges may involve microscopic differences in price that last a matter of seconds. Futures markets in different areas of the world may have slight disparities in the prices of certain goods, but as long as the disparities are small enough that the transaction costs of taking advantage of them would wipe out any potential profit, there's no point in attempting an arbitrage strategy.

However, for investors willing to assume a higher amount of risk, certain arbitrage opportunities frequently arise from proposed mergers between publicly traded companies.

Merger arbitrage
Corporate merger arbitrage opportunities fall into two basic categories: cash buyouts and stock buyouts. In cash buyouts, an acquirer offers to pay stockholders of the proposed target company a certain amount of money for their shares. In stock buyouts, the acquiring company instead offers to trade shares of its stock for those of the target company.

With cash buyouts, the arbitrage strategy is extremely simple. Usually, after a company makes a cash offer to buy the stock of another company, the target company's stock rises sharply, but lingers at a level slightly below the offer made.

For example, take the recent buyout offer for Yankee Candle. Before the offer, Yankee shares were trading in the high $20s. The prospective buyer offered $34.75 per share; immediately after the announcement, the stock rose to between $33 and $34.

The difference between the buyout price and the trading price can be explained by two factors. First, there is a lag between the time a buyout is announced and the time investors receive the actual cash payment; in Yankee's case, it was projected for early 2007. Second, there is always at least a small risk that the merger will not go through, in which case the stock may descend to its pre-announcement levels. If the merger goes through, however, arbitrage investors get to pocket the difference. It may be a small profit, but it could far exceed the returns you would get from other investments on an annualized basis.

Stock buyouts are a bit more complicated. For instance, in October 2006, the Chicago Mercantile Exchange (NYSE:CME) proposed a merger with the Chicago Board of Trade (NYSE:BOT). For every 10 shares of CBOT investors hold, the terms of the merger would give them slightly more than three shares of CME. CBOT's share price rose sharply on the announcement; the day before this article was first published, CBOT shares closed at roughly $151, while CME shares traded for $512.

To use merger arbitrage for a potential profit, you would have bought 10 shares of CBOT and sold short three shares of CME. The short sale would have given you a total of $1,536 in proceeds, while buying CBOT shares would only have cost you $1,510. If the merger went through, you'd then receive three CME shares, which you could use to cover your earlier short sale.

It's important to understand the considerable risks of merger arbitrage. Before a merger can take place, it must clear several hurdles. Regulatory agencies may have to approve mergers involving companies in certain industries. If the proposed merger raises antitrust concerns, the Department of Justice may review the terms of the merger and its effect on its market segment, to determine whether its consequences may contradict antitrust laws.

For cash mergers, the acquiring company must secure enough financing to pay target shareholders. Overall market conditions can also change, making what originally would have been a profitable combination no longer viable. Last spring, investors in salon operator Regis (NYSE:RGS) discovered that the hard way, when potential acquirer Alberto-Culver (NYSE:ACV) backed out of merger talks. Although companies usually work hard to overcome these obstacles, it only takes one failed merger to wipe out the profits of several successful deals.

The lure of easy money draws investors to seek profits from arbitrage opportunities. As long as you understand the risks involved, a close examination of proposed mergers can help you discover ways to make good short-term returns on your investment.

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This article was originally published on November 10, 2006.

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David Meier updated this article, which was originally written by Dan Caplinger. David doesn't own any shares of companies mentioned in this article. The Fool's disclosure policy is risk-free.