I want to look at how you can use options to profit from very specific scenarios, which I refer to as “special situation” trades.
The three areas I’m looking at are; mergers and acquisitions, earnings reports, and extreme moves. The first two categories would fall under predictive plays, that is, you take action before the event. The third would be considered reactive in that you respond after the fact.
Mergers and Acquisitions vs. Buy-Outs
Mergers, both real and rumored, are coming back in vogue, providing not only a catalyst for stock-price movement but also generating an increase in options activity. While overall merger and acquisition volume is near three-year lows, there are signs that with healthy balance sheets and a slowly returning sense of confidence, we might expect a dramatic pick up in activity in the second half of the year.
According to PriceWaterCoopers, 2019 began with U.S. Corporate having over $2.4 trillion in free cash and Private Equity firms still have over $3 trillion in uncommitted capital.
During the last cycle of merger mania, prior to the financial crisis retail companies, especially when those with large real-estate component were favored targets. The game was to level up and enjoy the free cash flow that the businesses generated, assuming the real estate provided a backstop for financing the debt.
This time around, we’re seeing more synergistic acquisitions, especially within the tech sector as companies like Broadcom makes a bid for Symantec.
While these will continue, I think there will also be a reemergence of private equity and activist investor hedge funds making plays for outright buyouts to take companies private.
Private equity firms are sitting on large funds whose capital needs to be deployed and have access to very low borrowing rates, making a return on investment targets easily achievable, even if a big premium is paid in the buy-out.
Identifying What’s in Play
While identifying what companies might make sense, as possible takeover targets, sometimes options activity can give an inside read that something is actually in play. Things to look for include:
-Increase in both stock and option volume. The options activity MUST include an increase in implied volatility.
-The options volume MUST exceed prior open interest which would suggest new buying.
-A shift in skew in which the front months carry a higher implied volatility than later-dated expiations. Remember, typically, an option chain has a horizontal line in which longer-dated options carry a higher implied volatility than the near-term options. This is due to the concept that the longer the time period, the greater the probability of a price move. But ,if there is an anticipated takeover, people will bid up the price of the front-month option. With this in mind, one strategy that might make sense is to short a diagonal calendar spreads. That is, buy a near-term option 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 towards their intrinsic value based on the takeover price. Meaning, most of the time premium will disappear. If a deal is announced, the value of the longer-term option you’ve sold short will decline relative to the value of the one you’re long on.
This strategy will be time-sensitive. If a deal isn’t announced or agreed to prior to the expiration of the front-month of the option, your long position will become increasingly exposed to the upside. For this reason, I’d suggest using a calendar spread, which the long call options have at least two months remaining until expiration, and exiting the position when there are less than three weeks left.
Second, while this above offers a very nice return, it’s capped by the width between strikes, meaning, if there was a 35% premium rather than a 15% premium bid, 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 will the actual results be, what are the options already pricing in, and what will the reaction be. For the most one can assume that implied volatility will decline immediately following the report.
For this reason, I suggest always using some type of spread, whether it be vertical, butterfly, or condor as described in the previous chapters, to offset the decline in IV when making an earnings play. And keep the size of the trade small as these are often speculative singular events, which won’t have time for a thesis to play out to a position to recover if you’re wrong.
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 usually would stay away from the lawsuits and accounting, as they fall under the “cockroach theory” in that there is usually more of those bad buggers than first appear.
Fading the News
But on the warnings, I will usually take a “fade” approach. That is, if a stock gets whacked on an earnings warnings, I might sell some puts spreads to set up a moderately bullish position. Being that the news is out, the first move is usually an overreaction and implied volatility. Initially, a jump price move came out of the blue. One can expect both price and implied volatility to stabilize once the news is digested.
SPY shares were trading at $292.96 per share on Tuesday afternoon, up $4.89 (+1.70%). Year-to-date, SPY has gained 18.31%, versus a % 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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