9 Weeks to Better Options Trading: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
Veteran options trader Steve Smith breaks down special situations.
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.
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