9 Weeks to Better Options Trading: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
Veteran options trader Steve Smith breaks down special situations.
Editor's note: To help investors profitably navigate the options market, Minyanville has launched "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers. Read the kick-off to the series here.
MINYANVILLE ORIGINAL It may be the ninth inning in the Nine Weeks to Better Options Trading series, but the game is far from over. Over the past eight weeks, I've addressed not only introductory-type concepts like option pricing and behavior and risk management, but also some key basic and not-so-basic options trading strategies.
Unlike many option primers, which tend to start their focus on the innards of options math, my approach is to provide instruction on how they work in the real world. The analogy would be that we don't need to know how to build an engine in order to drive. But to travel safely and efficiently, it certainly helps to have instruction in how the vehicle operates under different conditions. Hopefully, we now have a basic operating manual that will not only get us from point A to point B, but also teaches us what do when presented with adverse or unexpected conditions.
In today's piece, we're going to look at what are generally called "special situations," or events, both known and unknown, that can have a large impact on a stock's price, and how we can use options to predict and ultimately profit from the outcome. I want to look at three areas -- mergers and acquisitions, earnings reports, and extreme moves. The first two categories would fall under predictive plays -- that is, you take action before an expected event. The third would be considered reactive in that you respond after the fact.
Mergers and Acquisitions
Mergers, both real and rumored, may be coming back in vogue, providing not only a catalyst for stock-price movement, but for an increase in option activity. While overall M&A volume is near three-year lows, there are signs that with healthy balance sheets, low interest rates, and a slowly returning sense of confidence, we might expect a dramatic pickup in activity in the second half of the year
According to PricewaterhouseCoopers, as of the beginning of 2012, US corporate balance sheets had over $1.4 trillion in free cash, while private equity firms held in excess of $1 trillion in uncommitted capital. Last year, we saw a string of strategic corporate mergers, especially in technology, as firms like Intel (INTC), Hewlett-Packard (HPQ), and Amazon (AMZN) gobbled up young companies for huge premiums, handing out big profits for those that found themselves sitting on out-of-the-money calls. These land grabs are hard to predict and, Facebook-for-Instagram notwithstanding and unplayable anyway, they have somewhat subsided of late.
Instead, we are seeing more synergistic acquisitions, like Roche's (RHHBY) play for Ilumina (ILMN), Energy Transfer Partners' (ETP) recent bid for Sunoco (SUN), and Coty's offer for Avon (AVP). In deals like these, companies look to mix and match parts to fill in product lines and/or boost top-line revenue as organic growth stalls.
While these types of transactions may continue, I think the best money-making opportunities overall will come in the reemergence of private equity and activist investor hedge funds making deals to take companies private. A great example of this was the recent purchase of PF Chang (PFCB) by Centerbridge Partners for $1.1 billion, or a 30% premium to the prior day's close.
I think mature retailers, with their relatively modest capital expenditure requirements and good cash flow will be prime sector targets for takeovers. Two names I think are ripe are Abercrombie & Fitch (ANF) and Urban Outfitters (URBN). Both have recognizable and respectable brands, but have stumbled and are ready to be turned around by skilled managers.
Identifying What's in Play
Trying to predict a takeover is extraordinarily difficult. However, options activity can give an inside read that something is actually in play. Things to look for include:
- An increase in both stock and option volume, accompanied by an increase in implied volatility.
- Option volume that exceeds prior open interest, which suggests strong new buying.
- A shift in skew with front-month options carrying a higher implied volatility than longer-dated options. Typically, longer-dated options carry a higher implied volatility than the near-term options. This is because the longer the time period, the greater the probability of a big price move. But if anticipation of a takeover builds, traders will bid up the price of a front-month option on expectations of a near-term move.
With this in mind, one strategy that might make sense is to short diagonal calendar spreads. This means that we buy a near-term closer-to-the-money call, and sell a longer-term option further out-of-the-money call. If a deal is announced, both options will move toward their intrinsic value based on the takeover price because most of the time premium will disappear. As well, 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; in Abercrombie & Fitch, with shares trading around $52.50 one can:
- buy the August $55 call for $4.20 a contract
- bell the January $60 call for $5 a contract
This is an $0.80 credit ($5 - $4.20). Assuming Abercrombie is bought prior to August expiration for any price above $60, the position will be worth $5. That is the spread between the long $55 call and the short Jan. $60 call. Plus, you keep the $0.80 credit you collected, giving a profit of $5.80.
However, this strategy comes with very important caveats to which you absolutely must pay close attention.
This strategy is time-sensitive. If a deal isn't announced or agreed to prior to the expiration of the front month of the option, the short January call position will become exposed to the upside. Therefore, I would suggest structuring the calendar spread in which the long calls have at least two months remaining until expiration, and exiting the position with at least two weeks to go until those calls expire. If the deal fails to materialize before those front month options expire, you will find yourself naked short the longed dated calls you sold, exposing yourself to unlimited losses -- the type of losses that can take you out of the trading game altogether.
Also, be aware that while the above strategy offers very attractive potential returns, they are capped by the width between the strike prices, meaning if a big takeover premium is offered, some money would be left on the table.
Earnings are always tricky in that there are many moving parts that need to be gauged; what is expected, what the actual results are, what the options are pricing in, and what the reaction will be.
One can usually assume that implied volatility will decline immediately following an earnings report. For this reason, I always suggest using some type of spread when playing earnings, whether vertical, butterfly, or condor, as described in previous articles (see the list below), to offset a decline in IV. Also, it makes sense to keep the size of earnings-driven trades small as these are often speculative singular events in which you won't have time for a thesis to play out, or for a position to recover if you are wrong.
For example, Digital River (DRIV) is set to report earnings on Thursday. The implied volatility of the May options is running around 55%, higher than the 30-day average of 41%, and also well above the 30-day historical volatility at 35%. Following the report, no matter what the results turn out to be, one can expect implied volatility to revert to the mean, or around the 41% level.
This means that all else being equal, the May $19 calls, currently trading around $0.80, will lose about $0.15, or 18% of their value after the report. That likely decline in implied volatility means the purchaser of calls has a major headwind to overcome. To help mitigate this "post earnings premium crush" (PEPC), one could consider selling the $21 calls for around $0.30 to create a $19/$21 vertical spread. Again, no matter what happens, those $21 calls sold against the $19s will also suffer a PEPC, helping offset the implied volatility value lost in the long calls.
These occur when a company warns of a profit shortfall and or raises guidance before the official earnings release, a sudden change in management, or other unscheduled news events such as lawsuits or accounting issues. I generally stay away from issues of lawsuits and accounting as they fall under the "cockroach theory" -- that is, there are usually more of those bad buggers around than first appear. In most cases, the best move is no move.
Fading the News
However, on warnings and shortfalls, I will usually take a "fade" approach. That is, if a stock gets whacked on an earnings warning, I might sell some put spreads to set up a moderately bullish position. When big news hits, the first move is usually an overreaction, and implied volatility will initially jump dramatically. Subsequently, one can expect both price and implied volatility to stabilize once the news is digested.
One example of this came back in January, when JC Penney (JCP) shares jumped some 25% on the announcement that Ron Johnson -- the brains behind the Apple Store (AAPL), gush gush -- was taking over. He may be a genius, but the stock was clearly pricing in a lot of good things that would take some time to play out. Selling call spreads proved to be a safe and simple way to fade the news.
Wrapping It Up
I thoroughly enjoyed writing up this series, and I hope it proved helpful as an introduction to the versatility of options.
More importantly, I hope it sparked even more questions and interest in learning about options, and I look forward to your feedback so I can build on this series over time.
In the meantime, if you have any questions regarding options or feedback on the series, feel free to drop me a line.
Here is a complete index for the 9 Weeks to Better Options Trading Series:
Week 1: 5 Rookie Mistakes Options Traders Make
Week 2: Option Pricing Basics: Understanding Implied Volatility and Time Decay
Week 3: Trading Strategy: The Power of Calendar Spreads
Week 4: Trading Strategy: Butterfly Spreads
Week 5: Trading Strategy: Iron Condors
Week 6: Trading Strategy: Risk Reversals
Week 7: Trading Strategy: Back Spreads
Week 8: Managing Risk
Week 9: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
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