Takeover activity has picked up over the past six months — 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, 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 of private equity firms using the cheap cost of capital buyout for cash flow -positive businesses. Just last today, Red Robin Burger (RRGB) shares popped over 10% after receiving a buy-out bid Vintage Capital for $40 a share. Which would be 30% of yesterday’s closing price.
This is reminiscent of the last stages of circa 2006-2007’s 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, determine how we can profit from such activity without taking too much risk.
Options for Takeovers
Each deal comes with various specifics from 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 capturing 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 one is purchased, usually for a debit, this is considered being long on 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 finance 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 valued 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 example that will allow us to focus on the numbers and reasoning for using such an approach. Even with today’s 10% pop shares trading some 18% below the proposed $40 takeover bid.
One could buy the December $30 call and sell the September $40 call for a net debit of $4.00. If a deal occurs near the expected range, by the end of summer, the spread will be worth $10 or a 150% gain.
The worst-case scenario would be if the share price merely meandered between $30 and $35 for the next few months and one could then look to sell October 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.
RRGB shares were trading at $34.68 per share on Friday afternoon, up $4.08 (+13.33%). Year-to-date, RRGB has gained 29.79%, versus a 20.67% rise in the benchmark S&P 500 index during the same period.
Steve Smith has more than 30 years of investment experience and an expert level of options knowledge. He was a seat-holding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to August 1997. In 1998, he joined TheStreet.com as the senior option columnist and chief derivatives strategist. In 2003, he launched an option-based newsletter, OptionAlert, which was awarded the MIN “Best Business Newsletter” in 2006. In 2009, he joined Minyanville as a contributor and launched the proprietary OptionSmith newsletter. In 2010, he joined New Vernon Capital, a family of hedge funds with over $2 billion of assets under management, as risk market consultant to utilize option strategies to reduce portfolio exposure and enhance returns for the four main funds. In 2015 he began working at the Adam Mesh Trading Group, where he currently authors theOption Sensei newsletter and manages the Options 360 advisory service.
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