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How Options Traders Can Play Mergers

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A shift in the reason deals are made requires a shift in strategy.

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Measuring Mergers

Mergers, both real and rumored, are coming back in vogue, providing not only a catalyst for stock-price movement, but also generating an increase in option activity. But unlike the private-equity buyout boom -- which was fueled by cheap money and driven by overly optimistic cash-flow projections that offered all cash and huge premiums -- this latest round of mergers is different. Baker Hughes (BHI) for BJ Services (BJS); Disney (DIS) for Marvel (MVL); and now the potential Kraft (KFT) for Cadbury (CBY) are about strategic consolidation, cutting costs, and improving margins and market share. And they're being funded, in a large part, by stock.

For option traders, this shift in the reason deals are done will require a shift in how they're played -- and which strategies might work best.

Mergers Versus Buyouts

In the private-equity buyout boom, many took a swing for the fences approach, purchasing out-of-the-money calls on numerous names in the hopes that one would be a home run and have profits exceeding the cost of all the other strikeouts. This drove up the implied volatility of the options on takeover rumors -- especially names in retail or businesses that had a real estate component.

Among the reasons the big option premiums were warranted is that the deals tended to be fairly clean; there was often a deadline for a vote and management was usually aligned with the private buyers (yes, there was often a conflict of interest). And since it typically wasn't a consolidation, there were few anti-trust issues. Often it was just a matter of whether it would take a higher bid to push the deal through.

Takeovers that include stock, which can be billed as mergers, may be less explosive, but might be safer and offer better probability of profits. With the private-equity deals, there was no real arbitrage and there were limited ways to hedge; either the deal happened or it didn't. The current crop of deals are likely to play out on a longer time line and see a more gentle ebb and flow of valuations based on market conditions and current share prices.

One thing both have in common is that once a deal is announced, the implied volatility of the options is likely to decline.
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No positions in stocks mentioned.

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