Special Trades For Special Situations
Takeovers, stock buybacks, class action lawsuits, bankruptcies, etc., are special situations that offer special trading opportunities. As an example, let’s consider a hypothetical takeover with invented numbers.
Suppose stock XYZ has been presented a takeover offer that has not yet been accepted by all the parties involved (and thus is not certain), but the final decision will be made shortly, say in three weeks. Suppose XYZ is trading at 50, was trading at 40 prior to the takeover offer, and has a takeover price of 60. Suppose also that you determine, either through analysts’ estimates, your own analysis, or market pricing, that the probability of the takeover going through is 50%.
So there is a 50% chance that the stock will be worth 60, and, ignoring other market factors, a 50% chance that the stock will return to its prior value of 40. Now suppose there are options on the stock and that a three-month call option is selling for 5. How can you exploit this special situation?
If the takeover goes through, XYZ will be worth 60, and the three-month call option will be worth a little more than 10; if it does not go through, XYZ will be worth 40 and the three-month call option will be worth around 1 or so, depending upon the prior volatility of XYZ. If you merely purchase the call option for 5, you have an asset whose value in three weeks will be (approximately) either 1 (with a 50% chance) or 10 (with a 50% chance). The price of 5 is about right, as 5 equals about 50% of 10 plus 50% of 0. (Actually, because of the residual time value that will cause the option to be worth a little more than 0 or a little more than 10, the option is worth a little more than 5, but let’s ignore this refinement for now).
If you purchase the three-month call for 5 and wait to see what happens, you will on average (meaning in a large number of identical situations) break even on the trade. Suppose, however, you do something a little cleverer: suppose you purchase two of the calls and sell XYZ short. What happens to this position if the takeover is successful, or if it fails?
If XYZ trades up to 60, you will lose 10 on your short position. But you will gain a little more than 10 on you two calls–if the call becomes worth 11, your profit on the calls will be 12. In this case you will show a net profit of +2, ignoring commissions. If XYZ drops to 40, you will gain 10 on your short position and lose about 4 on each of your long calls, for a net profit of +2 again.
This is a riskless trade. In the next few commentaries, I will explore other strategies in this hypothetical situation, looking at what happens if the call option is priced differently, at strategies involving the three-month put option, etc. For practice, you might take a look at other possible strategies yourself and compare your analyses with the ones I will present.