The Options Way to Play Takeovers

Maybe it’s the lack of organic revenue growth. Or the low cost to borrow money. Most likely the combination of the two, but we have seen a spate of merger and acquisition activity of late.

The most high profile has been AT&T’s (T) $80 billion takeover of Time Warner (TWX), but others, in just the past week, included Rockwell Collins (COL), which will buy B/E Aerospace for $6.4 billion and Toronto-Dominion Bank, parent of TD Ameritrade’s (AMTD) will purchase privately held Scottrade for $4 billion. All told, October is shaping up to be the most active month of M&A since 2003. And many expect the number of deals to accelerate heading into the end of the year.

Each deal comes with various specifics, from the form of payment being cash or stock, the premium offered, to regulatory hurdles that can impact the time frame to closing. Trying to capitalize on a broad trend of M&A by simply buying call options is basically throwing darts. You may hit a bullseye, but unless you are an expert or have some special knowledge, it will usually take a lot of throws. Let’s look how options can be used to take a more conservative approach to capturing value if a merger does occur and minimize the losses if it doesn’t.

This options strategy will let you speculate on takeovers while minimizing the risk.

Selling the Calendar Spread

The approach I’m taking is an atypical use of a calendar, or time spread. Some quick definitions:

-A calendar spread consists of buying and selling calls (or puts) with different expiration dates.

-If the near term option is sold and the longer dated purchased, usually for a debit, this is considered being long the spread. It is mostly employed on the expectation of a gradual move higher or lower in stock price. The notion being the sale of the near term option helps finances the cost of the longer dated option.

– A diagonal calendar spread refers to using two different strike prices to gain a more directional bias. Typically this would involve buying a longer dated closer to the money option and selling the near term further out of the money option. This approach costs money, or is done for a debit and its profitability is dependent on clearing that cost basis.

For a potential takeover play we are going to turn these typical approaches on their head. That is; buy a lower strike call and sell a longer dated higher strike call. This strategy will be done for a credit and will profit if a takeover is reached regardless of the price.

The reasoning is that once a deal is announced and agreed upon all options will approach their intrinsic value. The concept is that once a deal occurs, all options across all expirations will drop in implied volatility, essentially losing their time premium and be valued at intrinsic value.

Meaning the time premium of the longer dated calls will evaporate given the upside potential of the stock has been eliminated. Let’s look at an example that will allow us to focus on the numbers and reasoning for using such an approach.

One of names constantly the subject of takeover speculation is cyber security firm FireEye (FEYE). A few months ago management even went as far to say they had turned down not one but several offers in the $30 per share range. With the stock now sitting below $13, maybe they should have taken the bid.

Let’s assume someone does come back to the table with a $15-$17 bid – a full 30% to 50% premium from bid from the current price – within the next 6 months. How might we play that?

I would look at buying the June 12 call and sell the January 2017 17 call for a $2.00 net debit.

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If the company gets bought for any price above $17 the spread will go to a maximum value of $5 for a $3.00 or 150% gain.

The worst scenario would be if share price merely meandered between $12 and $17 leading into the June expiration. For this reason I would exit the position by the end of May, no matter what.

By selling a diagonal calendar spread for a credit one can take advantage of a takeover or merger without having to predict the exact price or timing.

— Steve Smith

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About the Author: Steve Smith