Yesterday, financial media revitalized the term “merger Monday” as some $60 billion in deals were confirmed.  A few such as LVHM’s bid for Tiffany (TIF) has surfaced a few weeks ago. But, others such as Schwab’s (SCHW) move to acquire TD Ameritrade (AMTD) came to light just recently, and Novartis (NVS) purchase of Medicines Co. (MDCO) came as a surprise and sent shares surging. 

Overall, takeover activity has picked up over the past six months, and 2019 is now on pace for the most active year for mergers and acquisitions, in terms of both the numbers of deals and dollar amount, since 2013 when companies started to sort through the post-financial crisis landscape. 

This time around, it’s the lack of organic revenue growth as we enter the later innings of economic expansion and the low cost to borrow money, which has spurred the merger and acquisition activity. 

There has also been a notable increase in private equity firms using the cheap cost of capital buyout cash flow positive businesses. For example a few months ago, Red Robin Burger (RRGB) shares popped over 10% after receiving a buy-out bid Vintage Capital for $40 a share. Shares have since slumped back to $27. But, the rumors persist. 

This reminiscent of the last stages of circa 2006-2007 pre-crisis, as anything with a real estate component, was levered up with debt, taken private, and we know that ended. 

But, we’re not here today to judge or make a forecast. Rather, how do we profit from such activity without taking too much risk? 

Options for Takeovers 

Each deal comes from various specifics in the form of payment cash/stock, the premium offered, to regulatory hurdles that can impact the time frame to closing.  Trying to capitalize on a broad trend of M&A by simply buying call options is basically throwing darts. You may hit a bull’s eye. But, unless you are an expert, or have some special knowledge, it will usually take a lot of throws.   

Let’s look at how options can be used to take a more conservative approach to capture value if a merger does occur, and minimize the losses if it doesn’t. 

This options strategy will let you speculate on takeovers while minimizing the risk. 

Selling the Calendar Spread

The approach I’m taking is an atypical use of a calendar or time spread.  Some quick definitions:

-A calendar spread consists of buying and selling calls (or puts) with different expiration dates.  

-If the near term option is sold and the longer-dated purchased, usually for a debit, this is considered being long the spread.  It is mostly employed on the expectation of a gradual move higher or lower in stock price. The notion being that the sale of the near term option helps finances the cost of the longer-dated option.

– A diagonal calendar spread refers to using two different strike prices to gain a more directional bias.  Typically, this would involve buying a longer-dated closer to the money options and selling the near term further out of the money option.  This approach costs money or is done for a debit and its profitability is dependent on clearing that cost basis. 

For a potential takeover play, we are going to turn these typical approaches on their head.  That is; buy a lower strike call and sell a longer-dated higher strike call. This strategy will be done for a credit and will profit if a takeover is reached, regardless of the price. 

The reasoning is that once a deal is announced and agreed upon, all options will approach their intrinsic value. The concept is that once a deal occurs, all options across all expirations will drop in implied volatility, essentially losing their time premium, and be at intrinsic value.  

Meaning, the time premium of the longer-dated calls will evaporate, given the upside potential of the stock has been eliminated.   

Let’s look at the above mentioned Red Robin as an example that will allow us to focus on the numbers and reasoning for using such an approach.

Let’s assume a bid does emerge in the $40 per share range, which would a 45% premium to the current price. 

One could buy the March 2020 $30 call and sell the January 2021 $35 call for a net debit of just $1.00

  If a deal occurs near the expected range by the end of the first quarter or the March 20 expiration, the spread will be worth $5 or a 400% gain! 

The worst scenario would be if share price merely meandered between $30 and $35 for the next few months with no bid in sight. At that point, you could then look to sell March 2021 calls to reduce cost basis. 

Using a diagonal calendar spread for a credit, one can take advantage of a takeover or merger without having to predict the exact price or timing.  

AMTD shares were trading at $51.23 per share on Tuesday morning, down $0.55 (-1.06%). Year-to-date, AMTD has gained 7.28%, versus a 27.33% rise in the benchmark S&P 500 index during the same period.

About the Author: Option Sensei

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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