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