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Playing A Takeover

By Len Yates

An enormous amount of options activity accompanies
takeovers and takeover rumors, and these can be gold mines of
opportunity. Yet you must be careful.

One way to play
takeovers is to bet on the price. If you want to play it to the upside (as these
things often do go much higher after the initial news or rumor), you can
pick a call to purchase, or open a vertical debit spread in calls or a vertical
credit spread in puts.

Or, you can use some
good analysis tools and do some volatility-based trading. This approach can be
very safe and lucrative. Returns are more predictable, as you do not have to
guess the direction of the underlying security. 

Volatility-based
trading does, however, require some finesse. Playing a takeover is like flying
your plane through a storm. The figures can lie to you.  What seems like a
profit opportunity may not be. You have to be careful how you interpret the
numbers.

As I write this
article, R.J. Reynolds is awaiting a Nabisco shareholder vote about its being
acquired. In anticipation of this vote, Nabisco’s nearby options are inflated to
higher premiums than its farther-out options. For example, the October calls are
trading at an implied volatility of 37%, while the December calls are trading at
only about 18%. A similar differential exists in the puts.

This automatically
suggests opening a horizontal debit spread, selling the more expensive nearby
options and buying the cheaper farther-out options. But before rushing in, you
ought to stop and ask yourself, “Why are these options being priced this way?” 
Search for some logic that would possibly explain what you are seeing.

In Nabisco, traders
are probably giving the nearby options higher premiums because, if something is
going to happen with Nabisco, it’s going to happen very soon or not at all. The
expected near-term price volatility in Nabisco translates into a higher
volatility for the period from now to expiration of the October options than for
the period from now to expiration of the December options.

As you may know,
horizontal debit spreads have “the life squeezed out of them” when the price of
the underlying moves much higher or much lower.  Therefore, if you were to take
a horizontal debit spread in Nabisco right now, you would be accepting the
better odds (the apparent bargain) to bet on Nabisco staying about the same
price, against those who were accepting worse odds to bet on Nabisco taking a
big jump. Are the horizontal debit spreads such a bargain after all? Maybe not.

Big differences
between put and call implied volatilities can also occur. In the old RJR
takeover situation several years ago, there was to be a large dividend payout.
As you know, a dividend causes the stock price to drop the day the stock goes
“ex-div.” In this case, the dividend was to be so large that all the puts seemed
extraordinarily overpriced and all the calls were “flat.” Naïvely selling the
expensive puts might have been ruinous if it weren’t for the fact that RJR stock
continued higher. Finding out about such a dividend, you would enter it into
your option-pricing model. As soon as you did, the calls and puts would seem to
be more normally priced.

In more current
news,
Cendant has offered to purchase all outstanding shares of Avis that Cendant does
not currently own, at a price of $29 per share in cash. However, Avis has hired
a firm to advise it on the Cendant proposal, as well as other strategic
alternatives available to the company. As I understand this, Avis stock has an
apparent floor at $29 and the potential to go higher than its current price of
30.5. At the same time, the Avis March 35 calls (IV=18%) are undervalued in
relation to other Avis call options, and should possibly be bought. Or, the
December 25 puts are overvalued (IV=55%) and might be sold naked.  (See figure
below.)

Takeovers can be
profitable — just be shrewd. Don’t be naïve in how you read the numbers. If you
see something strange, try to figure out why it is that way. Read everything
about the situation. Dig into the arithmetic of the deal and learn of any ratios
that may apply. Then, once you’re sure, act fast!  Option trading opportunities
in takeovers can come and go quickly.