Once again it is time for my favorite reoccurring character to write, "The Vew From the Virtual Option Pit." I hope you guys enjoy as much as I do. Tomorrow I will be giving a very important execution tip to our readers. It is a MUST read.
A fun, risky, and possibly rewarding trading environment presents itself when strong rumors of a takeover arise. It's interesting to watch how options can react during the time from initial rumor to momentum building to the mass populace making the stock leap higher as the news (if anything credible) is digested. Besides watching single option levels react, I like to observe what is happening to time spreads (short calendars). These days it is rare, but not completely unheard of, that certain options “left unattended” can provide great deals when priced relative to the “hot list” of the front month.
As rumors build about a possible takeover, especially one solely with cash, the time spreads start to come in reflecting the loss of time premium if indeed a deal does take place. Many a time I've gotten lucky to scoop a 2 or 3 month ATM (At-The-Money) call as little as a quarter or dime over where the front month is trading (on the rare occurrence buying the time spread for a nickel or even!). Keeping in mind where implied volatility of the underlying trades, it's a good way to trade the activity, and fun to watch time-spreads expand back to their norm when the rumors are squashed and activity dies down. In May, when the Sybase deal was announced to be mostly guaranteed, there was a good 45 minutes to leg into short Jun-May spreads for as much as $.70 which were trading for $.05 the morning after it became official.
This said, one has to be careful not to be caught too big on 1 side or the other (being long or short the spread). A current example is Genzyme “GENZ”. Traders trying to take advantage of collapsing time spreads were quick to sell the Sep-Aug 70 call spread anywhere over $1.05 (selling Sep and Buying AUG).
Though it did fluctuate and come down to as low as $.75 for a brief moment, it soon expanded to as high as $1.45 when reports surfaced that the deal may not be accepted as soon as everyone was expecting (Notice that SEP and AUG are the same VOL Below).
Is there a sure-fire approach to being on the right side of these spreads? Absolutely not! With prudent position management, however, a trader can be profitable in possible takeover situations. Knowledge of historical volatilities is important, as well as the underlying price before any type of chatter evolved (especially when calculating risk of where things go if the offer is withdrawn). Obviously, staying on top of news reports is key, as is following the paper flow and any new terms of the possible deal. At the very least, this illustrates another type of play in the options markets which can be, if not necessarily profitable the first time around, a valuable lesson for future deals.
Thanks again ODI for continuing to contribute here at Option Pit. You are such a resource for the Option Pit Blog Readers.
