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How Options Traders Can Play Mergers

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The shift in why deals are being done requires a shift in how they're being played.

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Merging Options

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, this latest round of mergers -- such as Coke (KO) for Coca-Cola Enterprises (CCE) -- is strategic consolidation, cost-cutting, improving margins and market share, and being funded in large part by stock. But they are still offering up large premiums as seen in Millipore (MIL), and now the current activity in the fertilizer space involving CF Industries (CF) for Terra Industries (TRA) where a minor bidding war has broken out.

For option traders, this shift in the "why deals are done" will require a shift in how they're played and which strategies might work best. An important aspect of takeover plays is once a deal is announced, the implied volatility of the options is likely to decline -- sometimes dramatically, depending on the perception of how likely and at what price the deal will be consummated.

I Knew That Skew

Typically, an option chain has a horizontal in which longer-dated options carry a higher implied volatility than the near-term options. This is due to the concept that the longer the time period, the greater the probability of a price move. Remember, implied volatility is basically an artificial measure of time.

For example in Apple (APPL) -- which I don't think anyone thinks is being bought out anytime soon -- the April $210 calls carry an IV of 27% while the January 2011 calls of the same strike have a 31% implied volatility.

Now take a look at OSI Pharmaceutical (OSIP), which recently had a hostile bid that was a 100% premium above the stock's prior price. While OSI's board has rejected the offer, the option market is betting a deal will go through. This is evidenced by the fact that the April options carry an IV 23% while the July options have contracted to a mere 15% level.

The reason for this reverse skew is that if a deal is announced, the premiums of the options will get squeezed immediately since the price of the deal, no matter what the premium, greatly diminished the likelihood of future price swings. Hence there's no reason to pay a premium for a longer-dated option, and they'll trade near intrinsic value.

Marking the Calendar

With this in mind, one strategy that might make sense is to a short calendar spreads in names that you think might come into play. That is, buy a near-term option and sell a longer-term option. If a deal is announced, the value of the longer-term option you've sold short will decline relative to the value of the one you're long.

For example, this morning Patriot Coal (PCX) is on the move on rumors that it's being eyed by Massey Energy (MEE) generating active call option trading and driving implied volatility of the March options by 25% to the 75% level this morning. Meanwhile the IV of longer-dated September options remains at the 60% level. In dollar terms, that means that the front-month options are increasing in value at a greater rate than the longer-dated ones, and if a deal does occur, the longer-dated options will lose all their time premium.

But bear in mind, this strategy will be time-sensitive. If a deal isn't announced or agreed to prior to the expiration of the front month of the option, you're long position will become increasing exposed to the upside. For this reason I'd suggest using a calendar in which the long call options have at least two months remaining until expiration, and exiting the position once there's less than three weeks.

As always buyer, or in this case seller, beware.

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No positions in stocks mentioned.

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